INTERMEDIATE THEORY OF THE FIRM

Objectives
By the end of this topic the student should be able to;

(a) Analyze perfect competition, monopoly, monopolistic competition, and oligopoly

(b) Discuss the welfare implication in each of these markets.

Introduction

This topic we analyze perfect competition, monopoly, monopolistic competition, and oligopoly

There after we discuss the welfare implication in each of these markets.

Consider whether the firm is maximizing profits if it produces quantity Oq1. It clearly is not, as
at this level of output MR equals q1B and MC is q1A and MC is q1B. As MR is greater than MC,
by producing an additional unit of output, the firm will add more to revenue than to costs, and
profit will increase. In general, we can state that if, for a profit maximizing firm, MR is greater
than MC and the firm should increase output.

Cost and revenue

A MC

B C E

MR

0 q1 q2 q3 Output

Profit Maximization

Now consider whether the firm is maximizing profits it it produces output Oq3. At this level of
output, MC equals q3C and MR is q3D. As Mc is greater than MR, by producing the last unit the

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firm has actually reduced profits. As long as MC is greater than MR, by producing less the firm
can reduce costs more than revenue. Thus, in general, we can state that if MC is greater than MR,
a profit maximizing firm should reduce output.

Taken together our two general statements imply that in order to maximize profits, a firm should
produce that quantity at which MC and MR are equal. Referring back to fig 4 in order to
maximize profits the firms should produce quantity Oq2, at which point both MC and MR are
equal; q2E. If we use the simple MC=MR rule for profit maximization, what is the profit
maximizing level of output in fig 5 where the MC curve cuts the MR

Cost and revenue

A B MR

0 q1 q3 q4 q2 Output

Fig 5.2. Profit maximization where MC cuts MR twice

Curve twice at points A and B? The simple MC= MR rule does not enable us to determine
whether output Oq1 or output Oq2 is the profit maximizing level of output.

Consider output Oq1: if the firm increased output to Oq3, say profit would increase as the MR is
greater than MC. Thus output Oq1 is clearly not the profit maximizing level.

Now consider output Oq2 if the firm reduced output to Oq4 say, profit would fall as MR is
greater than MC. Conversely, if the firm increased output above Oq2, profit would also fall as
MC is greater than MR. Output Oq2, therefore is the profit maximizing level of output. At this
level of output the MC curve is rising and cuts the MR curve from below. At output Oq 1 on the
other hand the MC curve is rising and cuts the MR curve from above. The profit, maximization
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rule requires some refinement. It now states that to maximize profits a firm should produce that
quantity at which MR=MC, provided the MC curve is rising so that it cuts the MR curve from
below at this point.

Any firm which is maximizing profits must be producing where MR=MC even if it does not
intentionally plan to equate MR and MC . The MR=MC rule applies no matter in what form of
market structure the firm operates.

The Model of Perfect Competition

Assumption of the Model

Ina perfectly competitive market, no individual buyer or seller has any influence over the market
so that market forces have full rein to determine price and output. Perfect competition is a
theoretical market structure based on a number of assumptions. The fulfillment of these
assumptions throughout the economy can be shown to lead to a Pareto optimal allocation of
resources. It is an impossible to make anyone better off without making someone else worse off.
Perfect competition is used by economists as a yardstick against which other market structures
are compared and evaluated. The model however cannot be realistically expected to exist in
totality in everyday life. Nevertheless, assume real world markets to contain a number of features
of the perfectly competitive model as, for example, some agricultural markets. The assumptions
of the perfect competition of the perfect competition model can be summarized as follows:

a) Many buyers and sellers

b) Freedom of entry and exit
c) Perfect mobility of factors of production
d) Perfect knowledge
e) Homogeneous product

It should be pointed out that the fulfillment of these assumptions in the absence of eternities
satisfies the operation of the price mechanism under perfect conditions as discussed in chapter 7.
The existence of many sellers means that no individual firm is able to have a significant effect on
the market. Each firm is small in relation to the size of the whole market and can effectively be

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regarded as facing a perfectly elastic demand curve format the ruling market price, it can sell
whatever it produces. Such a firm is described as a price taker. If the firm tried to set a price it
would sell nothing as with their perfect knowledge consumers would buy from the other
producers. Similarly, the firm would not set a lower price as this would reduce its revenue. Note
that while the individual firm faces a perfectly elastic demand curve, the market demand curve
for the product will normally be downward sloping. The existence of many buyers means that no
individual buyer has any influence over the market. Any collusion between buyers and/ or sellers
is also ruled out.

The assumption of freedom of entry and exit is almost self explanatory. It means that there are no
barriers to new firms entering the industry or to existing firms leaving the industry. I addition to
this mobility of firms there is the assumption of perfect mobility of factors of production. It is
assumed that land, labor and capital can switch immediately from one line of production to
another.

We have already referred to the assumption of perfect knowledge on the part of both buyers and
sellers. It is assumed that all participants in the market are perfectly well informed about prices,
quality, output levels and all the market conditions. As a consequence, there are neither
advertising costs for sellers nor search costs for buyers. This assumption is a sharp reminder of
the theoretical nature of perfect competition, as in reality the collection of information is often a
costly and time consuming chore.

The assumption of a homogeneous product implies that each unit produced is identical, so that
buyers can have no preferences between different units. Perfect knowledge and a homogeneous
product together imply that there must be a single market price for all units of output.

Prices and Output Determination in Short Run

Now consider the determination of price and output in the short run for an individual perfectly
competitive firm and for the whole industry, assuming profit maximization. The equilibrium
price is determined in the market for the good say good x by the interaction of supply and
demand. Figure5.3 (a) shows the market demand curve (DD) and the market supply curve (SS)
which intersect to give an equilibrium price Op1 and an equilibrium industry output OQ1.
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Figure 5.3 (b) drawn on a much bigger scale, illustrates the costs and revenue of a typical firm
earning above normal profit. The firm faces a perfectly elastic demand curve (DD), indicating
that it can sell all that it produces at the ruling market price Op1. The price the firm receives per
unit is given by total revenue divided by the number of units produced and is therefore the same
as average revenue (AR). In symbols we have

P = TR = AR
q
As the firm receives a constant price Op1 its AR is also constant. In addition, since an extra unit
of output can always be sold without reducing price, MR must also be equal to price. Thus in fig
5.3 (b) the demand curve facing the firm is labeled DD= AR=MR.

Price D S MC ATC

P1 p1 A B d= AR = MR

S D

0 Q1 0 Q1

a) Industry b) Firm

Fig.5. 3. Industry and firm in perfect competition earning above-normal profits

To find the equilibrium quantity that the firm will produce, we apply the MR=MC rule. The MR
and MC curves in the diagram intersect at the point where MC cuts MR from below. The profit
maximizing level of output therefore is Oq1. Note that the equilibrium price Op1 is equal to MC
at the equilibrium level of output Oq1. Since in perfect competition price and MR are equal,
profit maximizing firms which equate MR and MC will also necessarily equate price and MC is
the most significant feature of perfect competition and its welfare implications are discussed
below

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In fig5.3. (b), average total cost at output level Oq1 is q1B. Total costs which are given by
average total cost multiplied by quantity are thus represented by the rectangle Oq1BC. The cost
curves already incorporate an allowance for normal profit, which is the rate of return necessary
to keep the factors of production in their present use.

At the equilibrium level of output, total revenue is represented by the area of rectangle Op1Aq1.
Thus this firm is earning revenue in excess of total costs. It is said to be earning above normal
profits equal to the area of rectangle p1ABC. In the long run, the high level of profits in the
industry will attract new firms to enter the industry. The increased production will eventually
push down the price of the output, thus eliminating the above normal profits.

Firms making a loss

Consider now another perfectly competitive firm whose situation is illustrated in fig 7

Figure 5.7 (a) again illustrates the determination of the equilibrium price (Op1) in the market.
The cost and revenue curves of a typical firm are illustrated in fig 5.7 (b). Note that the ATC
curve lies completely above the AR curve, indicating that this firm cannot cover its full
opportunity costs. The intersection of the MR and MC curves at point A now indicates that the
loss minimizing level of output is Oq1. At this output, ATC equals Bq1, which is greater than AR
( = price) or Aq1. The loss per unit of output is equal to BA so that the total loss is represented by
the area of rectangle p1DBA.

As the price is above average variable cost (AVC) at output Oq1 the firm will continue to
produce in the short run, as it thereby minimizes its losses. If it shutdown production entirely, its
loss would be equal to its total fixed costs. By producing and selling output Oq1 at price OP1, the
firm more than covers its variable costs and can pay for part of its fixed costs.

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 D S MC

ATC

P1 p1 d= AR=MR AVC

0 Q2 Output 0 q1 Output

a) Industry b) Firm

Fig 5.7. Industry and firm in perfect competition making a loss

The firm’s short-run supply curve

We can note from the foregoing analysis that the perfectly competitive firm which aims to
maximize profits produces at the intersection of its horizontal MR curve with the MC curve
provided this is above the shutdown point. This is illustrated for different prices in fig 8. For
example, the firm offers for sale quantity Oq2 at price Op2. If price rises to Op3, the quantity
supplied by the firm increases to Oq3. We can see that the short-run supply curve of the perfectly
competitive firm is its MC curve above the intersection with the AVC curve.

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Costs, p4 MC

p3

p2 AVC

p1

0 q1 q2 q3 q4 Output

Fig 5.8. A firm’s short-run supply curve

The short-run industry supply curve is obtained by the horizontal summation of the MC curves
of the firms comprising the industry. This is illustrated in Fig.5. 9 for an industry containing only
two firms.

The two left-hand diagrams illustrate the MC curves of firms A and B respectively. At a price of
sh10, firm A produces 25 units and firm B 35 units of output per time period. Industry output at
this price therefore is 60 units and A is one point on the industry supply curve. Summing the
firms' outputs at other prices enables the industry short-run supply curve, SS, to be derived.

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 MC MC MC

10 10 10

0 25 0 35 0 60

Firm A Firm B Industry

This is the supply curve which (together with the market demand curve for the good) determines
the market price which all the individual firms have to take as given.
Costs

p1 d= AR=MR

0 q1 Output

Fig 5.10. The long run equilibrium of a perfectly competitive firm

The Long run equilibrium of the perfectly competitive firm

Figure 5.10 illustrates a perfectly competitive firm's long-run average cost (LRAC) curve. It was
noted above that if above-normal profits can be earned, in the long-run new firms are attracted
into 'the industry, so that the above-normal profits are eventually competed away. Conversely, if
the typical firm is making loses firms will begin to leave the industry in the long-run, with the
result that price rises until normal profits are restored.

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In the long-run equilibrium position, the perfectly competitive firm earns only normal profits. In
Fig. 5.10, the equilibrium price is Op1 and the equilibrium output is Oq1. Note that in this
situation, production is carried on at the lowest point on the LRAC curve. Price equals both
marginal cost and average cost. The firm is earning sufficient revenue to cover its full
opportunity costs. There exists no incentive for firms to enter or to leave the industry.

The perfect markets- a mathematical approach

The perfect markets have infinite number of competitors, deal with homogenous products, are
price takers, there is free entry and exit, perfect information. The demand curve is perfectly
elastic.

TR  P Q
AR  p
MR  p
AR  MR  p

The marginal cost curve cuts average cost curve from below and at its minimal point. i.e.

TC
AC 
Q
TC  AC  Q
TC AC Q
  Q  AC
Q Q Q
AC
MC  Q  AC
Q

AC
For the equation MC  AC then Q must be zero. i.e. minimal point.

AC
If Q is negative, then AC  MC i.e. AC is above MC curve

AC
If Q positive, then AC  MC i.e. AC is above MC curve

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N.B: Every firm in the perfect market must ensure that its marginal costs equal the market price
in order to maximize profits. We therefore always derive a firm’s supply function. Suppose every

firm in a perfect market has a cost function given as C  Q  1 .

2

To determine the firm’s supply function, MC = P

MC  2Q and hence,
p  2Q
1
Q  p.......... ...Firm' s Supply function
2

1
Q p  100  50 p
If there were a 100 firms, the market supply function 2 .

There is a possibility of making profit or loss in the short run depending on the level of average
cost curve.

This is only in the short run because in the long run, some firms will exit the market when there
are losses and hence leading to a fall in the average cost curve. If there are excess profits, more
firms will join the industry raising the average costs. In the long run however, every firm makes
a normal profit as shown below:

In the long run

MC
Price AC

p MR  P

Quantity

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The equilibrium Price is equal to the minimum long run average costs.

E.g. Suppose every firm in a perfect market has the following cost function
C g   q 3  10q 2  28q. How much output will each firm produce to maximize profit and at

what price?

LAC  q 2  10q  28
LAC
 2q  10  0
Q
q5

p  min LAC  5 2  105  28

p3

Suppose the market demand function Q  600  50 p . So that at a price equal to p  3 , the total

market demand is given by Q  600  50 * 3  450

The optimal number of firms in this market is therefore 450  5 units per firm  90 firms .

Suppose a quantity tax of Ksh. 4 is introduced on every amount consumed.

p  3 4  7
Q  600  507 
Q  250

Number of firms

250
 50
5

Perfect competition and welfare

One of the arguments in favour of a competitive market structure is that perfect competition
leads to an efficient, or Pareto optimal, allocation of resources. Indeed, it can be demonstrated

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that an economy with perfect competition in all markets and with no external satisfiers all three
of the marginal conditions for Pareto optimality.

Assume once again that we are dealing with an economy with only two goods (food and cloth),
two factors (capital and labour) and two individuals (A and B). Consider the three marginal
conditions in turn.

Labour

Least-cost combination of labour and capital

Isoquant

Isocost line
0 Capital

The MRTS of One Factor of Production for Another Should Be Equal for All Goods

A profit-maximizing firm will choose that combination of factors at which the firm' isocost line
is tangent to an isoquant, as illustrated in Fig. 11: this ensures that the chosen output level is
produced at minimum cost. Since the slope of the isocost line is equal to the ratio of the prices of
the two factors and the slope of the isoquant is the MRTS, we can say that if the food producers
are profit maximizes, they will employ that combination of factors at which

MRTSF=PK
PL
where MRTSF is the MRTS in food production, PK is the price of capital and PL is the price of
labour.

Similarly, if the cloth producers are also profit-maximizes, they will employ that combination of
factors at which

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MRTSc= PK
PL
Where MRTSc is the MRTS in cloth production. In perfect competition, all firms face the same
prices for capital and labour, so it must follow that

MRTSF = MRTSc and the first condition is satisfied.

The MRS for every pair of goods should be equal for all individuals Recall from Chapter 4 that a
utility-maximizing consumer will choose that combination of goods at which his budget line is
tangent to an indifference curve, as illustrated in Fig. 5.12: this ensures that the consumer is on
his highest attainable indifference curve.

Food

Consumer equilibrium

Indifference curve

Budget Line

0 Cloth

Fig 5.12 consumer equilibrium

Since the slope of the budget line is equal to the ratio of prices the prices of the two goods and
the slope of the indifference curves the MRS, we can say that if A is a utility-maximizing
consumer, he will allocate his income in such a way that

MRSA = Pc
Pf

Where MRSA is consumer A's MRS, Pc is the price of cloth and Pf the price of food. Similarly, if
B is also utility-maximizing consumer, he will allocate his income in such a way that

MRSB = Pc
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 Pf
where MRSB. is consumer B's MRS.

Assuming, as we must do in perfect competition, that both A and B face the same prices for food
and cloth, it follows that

MRSA = MRSB. so that the second condition is satisfied.

The Common MRS Should Equal the MRT for All Pairs of Goods

We have seen that each consumer's MRS will be equal to the ratio of the goods'

MRSA=MRSB= Pc
Pf
Recall that the marginal rate of transformation (MRT) is given by the slope of the production
possibility frontier. As such it can also be regarded as the ratio of the marginal costs of producing
the two goods. That is

MRT= MCC
MCf

This result is illustrated in fig 5.13 where in making a small movement along the frontier from A
to B of cloth is given up in order to produce of extra food. Since moving along the frontier leaves
total costs unchanged (because all resources are fully employed at every point), it must be true
that
C x MCe = f x MCf

Slope of frontier = f = MCe = MRT

c MCf
From(1) and (2) above, we can say that for MRS to be equal to MRT, it is necessary that

Pe = MCe
Pf MCf
In perfect competition, where the food producing and cloth producing firms set their prices equal
to their marginal costs of production, this condition must be satisfied.

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We can conclude from the above that an economy with perfect competition in all markets and
with no externalities will be efficient in the Pareto sense. Of course, this does not necessarily
mean that such an economy will have an equitable distribution of income.

Food

Production possibility frontier

0 Cloth

Fig 5.13 . The production possibility frontier and the marginal rate of transformation

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Monopoly

A monopolist is a single supplier of a good or service for which there is no close substitute.

Problems of defining a monopoly

In general terms, we can say that the cross elasticity of demand between the monopolist's
product and all other products is low – in other words, a rise the price of monopolists product
leads to no significant increase in the demand for any other product. The definition of a 'close
substitute’ is however, somewhat arbitrary. For example are gas and oil close substitute for coal?
The answer is likely to depend on the use to which the fuel is put.

In the United Kingdom, British Coal may have a monopoly in the supply of coking coal for steel
production, but faces stiff competition from gas oil in the heating market.

Pure monopoly can best be regarded as a theoretical model as it is unusual to find a single firm
with a 100 percent market share. In the United Kingdom, the Monopolies and mergers
commission to can be asked to investigate a monopoly to determine whether or not it is operating
in the public interest; for this purpose, a monopoly is defined as a single firm or interrelated
group of firms controlling 25 percent or more of a market.

It is possible for a group of firms or countries to engage in collusion over prices or production.
Levels hence act as a monopolist. Such a situation is described as a cartel . Similarly the
organization of petroleum exporting countries (OPEC), which forced up oil prices in the 1970,s,
is an example of an international cartel. In what follows, we confine our attention to a single firm

Monopoly demand curve

He sets the price hence the amount he sells depend on price, i.e. the demand is a decreasing
function of price. i.e.
Q  f  p f ' 0

Specifically:
Q  b0  b1 p

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The demand curve is assumed to be linear with changing elastics at every one point.

p 
B

 p 1
A

p 0
0 C Q

Q
 b1
P
Q P
p  
P Q
P
At point B, p  b1  
0
0
At point C, p  b1  0
Q
At point A,  p  1

Now
TR  P  Q

But Q  b0  b1 p

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 b0 b
P  Q
b1 b1
TR  P  Q
b 1 
  0  Q Q
 b1 b1 
b 1
 0 Q  Q2
b1 b1
b0 1
AR   Q
b1 b1
b0 2
MR   Q
b1 b1
The MR is a straight line with the same interrupt as the demand curve but twice as steep
as

MR AR  D Q

The AR is the demand curve for a monopolist

Equilibrium requires that MR=MC and slope of MC be greater than slope of slope of MR
at intersection.

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 P

SATC
SMC

QM MR AR  D Q

 Q   TR Q   TC Q 
 TR TC
  0
Q Q Q
MR  MC
 2  2TR  2TC
  0
Q 2 Q 2 Q 2
slope of MR  slope of MC
e.g.
Q  50  0.5P , C  50  40Q
P  100  2Q
TR  PQ  100  2Q Q
 100Q  2Q 2
TR
MR   100  4Q
Q
FOC MR=MC
100 – 4Q = 40
60 = 4Q
Q = 15
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 P = 100 – 2Q
= 100 – 2(15)
=100 – 30
=70 units
MR MC
SOC  4, 0
Q Q
-4 < 0

The Multiplant Monopolist

- A monopolist who produces a homegenous product in different plants.
- For simplicity we shall assume two plants.

Assume the monopolist operates two plants A & B with a difference cost structure. He
has to make two decisions:
(i) How much output to produce altogether and at what price to sell it so as to
maximize profit.
(ii) How to allocate the proportion of the optimal output between the two plants.

The monopolist is assumed to know his market demand and the corresponding MR curve
and the cost structure of the different plants.

The total MC curve is a horizontal summation of the MC curve of the individual plants.

MC  MC1  MC2

The monopolist maximizes his profit by utilizing each plant upto the level at which the
marginal cost are equal to each other and to the common MR. This is *, if the MC of one
plant say plant A is lower than the MC of plant B, the monopolist would increase his
profit by increasing the production in A and decreasing it in B until

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 MC1  MC2  MR

Given that the market demand

P  f Q  f Q1  Q2 
And the cost structure of the plant
C1  f Q1 
C 2  f Q2 

The monopolist aims at the allocation of his production between plant 1 and 2.

To maximise profits
  TR  TC1  TC 2 
f.o.c
 
 0 and 0
Q1 Q2
 TR TC
  0
Q1 Q1 Q1
MR1  MC1
 TR TC
 
Q 2
Q2 Q2
MR2  MC 2

But MR1  MR2  MR given that each unit of the homogeneous output will be sold at the
same price P and will yield the same MR1 irrespective of the plant.
MR  MC1 
MR  MC1  MC 2
MR  MC 2 

S.O.C
 2TR  2TC  2TR  2TC
 and 
Q 2 Q12 Q 2 Q2

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 Q  200  2 P
P  100  0.5Q
C1  10Q1
C 2  0.25Q22
  TR  TC1  TC 2
TR  PQ
 100Q  0.5Q 2
MR  100  Q

MR  100  Q1  Q2 
MC1  10
MC 2  0.5Q2
MR  MC1

100  Q1  Q2  10
100  Q1  Q2  0.5Q2

Q1  Q2  90
Q1  Q2  100
 0.5Q2  10
 10
Q2 
 0.5
Q2  20
Q1  70
Q  20  70
 90
P  100  0.590  55
Obtain profit
Illustration

1. Suppose that you are hired as a consultant to a firm producing a therapeutic drug
protected by a patent that gives a firm a monopoly in two markets. The drug can be
transported between the two markets at no cost, so the firm must charge the same price in
both markets. The demand schedule in the first market is P1 = 200 - 2Q1, where P1 is the
price of the product and Q1 is the amount

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sold in the market. In the second market, the demand is P2 = 140 - Q2, where P2 is the price and
Q2 the quantity. The firm’s overall marginal cost is MC = 20 +Q1 + Q2. What price should the
firm charge?

2. Market demand is P = 64 - (Q/7). A multiplant monopolist operates three plants, with

marginal cost functions:
MC3(Q3) =6 +Q3
MC2(Q2) = 2 + 2Q2
MC1(Q1) = 4Q1
Find the monopolist’s profit-maximizing price and output at each plant.

Price Discriminating Monopolist

Exist when the same product is sold at different prices to different buyers.
Price discrimination (charging different prices for different consumers) offers the
monopolist, or any firm with market power, an opportunity to capture more surplus.
There are three basic types of price discrimination:
• First-degree price discrimination. The firm tries to price each unit at the consumer’s
reservation price (i.e., the maximum price that the consumer is willing to pay for that unit). For
example, when a firm sells a product at an auction, it hopes that consumers will bid up the price
until the consumer with the highest reservation price pays that price for the product. The seller
hopes that the price will be close to the maximum amount the winner is willing to pay for the
good.
• Second-degree price discrimination. The firm offers consumers quantity discounts—the price
per unit goes down if the consumer buys more units. For example, a software firm might set a
price of $50 per unit for consumers buying between 1 and 9 copies of a computer game, a price
of $40 per unit for 10 to 99 copies, and a price of $30 per unit for 100_ copies.
• Third-degree price discrimination. The firm identifies different consumer groups, or
segments, in the market, each with a different demand curve. Then, to maximize profit, the firm
sets a price for each segment by equating marginal revenue and marginal cost or, equivalently,
by using the inverse elasticity pricing rule. For example, if an airline identifies business and
vacation travelers as segments having different demand curves for flights on the same route, it
can charge a different price for each segment—say, $500 per ticket for business travelers and
only $200 per ticket for vacation travelers.
24 | P a g e
The conditions necessary which must be fulfilled for the implementation of price
discrimination are:
(i) The market must be divided into sub market.
(ii) Different submarkets must have different price elasticities.
(iii) There must be effective separation of the sub markets, so that no reselling can
take place from a low price market to a high price market. This condition
explains why price discrimination is easier to apply with commodities like
electricity or gas or services e.g. doctor which are consumed by the buyer and
cannot be resold.

Illustration
Suppose a railroad faces the following demand curves for transporting coal and grain for coal, Pc
=38 - Qc, where Qc is the amount of coal moved when the transport price for coal is Pc. For
grain, Pg=14 - 0.25Qg, where Qg is the amount of grain shipped when the transport price for
grain is Pg. The marginal cost for moving either commodity is $10.
Problem Equate marginal revenue and marginal cost to find the profit-maximizing rates for coal
and grain transport.
Solution Qc = 14 and Pc=24.
Qg = 8. Pg= $12 per ton-mile.

MR Vs price elasticity
TR  PQ
TR Q P
MR  P Q
Q Q Q
P
MR  P  Q
Q
 Q P
but  p 
P Q

25 | P a g e
1  P Q

p Q P
P 1 P

Q  p Q

Recall
P
MR  P  Q
Q
 1 P 
 P  Q 
  p Q 
1 
 P   P
  p 
1 
 P  P 
  p 
 1 
 MR  P1  
  
 p 

The Impact of Taxes on a Monopolist

For simplicity let us consider a firm with constant MC. When a quantity tax is imposed the MC
will go up by the amount of the tax. What happens to the price?

We consider a linear demand curve.

P  a  by
Where P is pice
Y is output

TR  py  a  by 
 ay  by 2
MR  a  2by

After a quantity tax t, the MC shifts up to the MC + t.

26 | P a g e
 Pr ice

After tax
P'
P* Before tax
MC  t
MC  C
AR  P

0 Q ' Q* Quantity
MR

The equilibrium moves to the left after the tax. Since the demand curve is half as steep as the
MR curve, the price goes up by half the amount of the tax.
Equilibrium before tax
MR=MC
But after the tax, the MC increases by the text such that:

MR  MC  t
But MC  C
a  2by  c  t
a  c  t  2by
2by  a  c  t
act
y* 
2b
y  1

t 2b

Recall that equal price is

27 | P a g e
P  a  by *
p
 b
y

P p Y 
  chain rule
t Y t 
1 1
 b   b 
2 2

Hence the price changes by less than the tax. Specifically for the linear dd, the price rise by ½
the tax.

Generally: In general, a tax may increase the price by more or less than the amount of the tax.

 1 
Recall: MR  P1 
  p 

But MR = MC

 1 
P 1    MC  t
 
 p 

MC  t
P
1
1
p

P 1

t 1  1
p

Since the monopolistic will always operate where the demand is elastic then he passes on more
than the amount of the tax.

28 | P a g e
Inefficiency of Monopoly
Recall, in a competitive market, P = MC.

In a monopoly, P> MC.

The price will be higher and the output lower, if a firm behaves monopolistically rather than
competitively. For this reason, consumers will typically be worse off in an industry organized as
a monopoly.
However, the firm will be better off by the same token if a firm behave competitively. Consider a
monopoly situation below:

price

MC

Pm em
Pc A B ec
C

AR  P

Ym Yc Output

MR

Suppose that we could somehow costlessly force this firm to behave as a competitor and take the
market price as being set exogenously. Then we would have ( Pc Yc ) for the competitive price
and output.

29 | P a g e
Alternatively, if the firm recognized its influence on the market price and chose its level of
output so as to maximize profits, we would see the monopoly price and output Pm Ym .

Recall that an economic arrangement is pareto efficient if there is no way to make anyone better
off without making somebody worse off.
Is the monopoly level of output pareto efficient?
Recall the inverse demand curve P(Y) measures how much people are willing to pay for an
additional unit of the a good. Since P(Y) is greater than MC(Y) for all the output levels between
Ym and Yc , there is a whole range of output where people are willing to pay more for a unit of

output than it costs to produce it. Clearly there is a potential for pareto improvement here.
Hence a monopoly would be inefficient.

But just how inefficient is he? Can we measure the total loss in efficiency due to monopoly?

The consumer’s surplus in the monopoly structure is Pm em Z which would go up by area A + B if

the monopolist behaved competitively.

On the other hand, the area A would just be a transfer from the monopolist to the consumer.

Under competition, the producer surplus would include area C. However due to the monopoly
charging the price Pm, he denies the consumer surplus (A+B). Out of this surplus, only A
benefits the producer while B is lost. Area C is also lost since the producer sells Ym instead of

Yc .

The Area B + C is known as the dead weight loss due to the monopoly. It provides a measure of
how much worse off people are paying the monopoly price than paying the competitive price.

It measures the value of the lost output by valuing each unit of lost output at the price that people
are willing to pay for that unit.

30 | P a g e
 Illustration
Suppose that a monopolist’s market demand is given by P =100 - 2Q and that marginal cost is
given by MC =Q/2.
a) Calculate the profit-maximizing monopoly price and quantity.
b) Calculate the price and quantity that arise under perfect competition with a supply curve P
=Q/2.
c) Compare consumer and producer surplus under monopoly versus marginal cost pricing. What
is the deadweight loss due to monopoly?
d) Suppose market demand is given by P = 180 - 4Q. What is the deadweight loss due to
monopoly now?

Criticisms of Monopoly

Long-run profits resulting from barriers to entry

A monopolist may be criticized on the grounds that he may be able to maintain above-normal
profits in the long-run because of barriers to the entry of new firms. As we have seen, this might
result in a redistribution of income that is not desirable on equity grounds. There are several
entry barriers which may have the effect of preventing the emergence of competitive firms.
Consider the following.

(a) High entry costs.

An existing monopolist, producing a large volume of output, may be benefiting from economies
of scale. This may mean that a new competitor, probably producing a low volume of output,
would be faced with higher per unit production costs and so would not be able to compete
effectively in the market. If the new firm were faced with heavy initial losses, it might never be
able to produce at a volume sufficient for it to enjoy comparable economies of scale.

(b) Legal monopolies.

In some cases, the state has created monopolies by law as, for example, with the Post Office in
the United Kingdom. In cases like these, it is illegal for rival firms to enter the industry.

(c) Patents and copyrights.

31 | P a g e
A monopoly may result from the holding of a patent on an invention or innovation. A patent
confers sole production rights for a given time period on those who have invested in research and
development to enable them to earn a return on their investment. A copyright restricts the
reproduction of printed or recorded material in a similar way.

(d) Ownership of natural resources.

The monopolist may be the sale owner of a natural resource. Unless new supplies of the resource
are discovered, there will be no possibility of new firms entering the industry. Consequently the
monopolist will have effective control over the supply of the resource and over the supply of any
manufactured products derived from the resource. In recent years, the oil exporting nations
formed OPEC (the Organization of Petroleum Exporting Countries) in order to act as a cartel and
so drive up the price of oil.

6.7. Increased costs:

Another possible criticism is that because a monopolist is not subject to conventional
competitive pressures, the quality of the good or service may decline as the consumer
cannot take his custom elsewhere. This charge, in fact was made against motorway
service areas in the United Kingdom and a committee was set up by the government to
investigate their operation; the committee reported in 1978 and made a number of
suggestions about how to improve the operations of these areas. It can further be
argued that a monopolist may settle for an easy life, and allow costs to rise
unnecessarily. The market power of the monopolist enables him to pursue objectives
other than profit maximization and still survive in the long run.

32 | P a g e
6.8. Possible benefits of monopoly
It should be recognized that monopoly can in certain circumstances have some
beneficial effects. The approach to monopoly policy in the United Kingdom is top
judge each case on its merits. So consider now the following possible advantages of
monopoly.
(a) Economies of single ownership .AS we have seen, the standard prediction that a
monopolist restricts output and raises price rests on the assumption that costs
remain uncharged when perfectly competitive industry is taken over by an
monopolist. It is most unlikely however that costs would remain unchanged in such
a situation. A monopolist may be able to benefit from economies of scale that are
not attainable by the individual perfectly competitive firms. It is even possible for
costs to fall so much that price will actually fall and output rise in the new
monopoly situation. This is illustrated in Fig6..4. The supply curve under conditions
of perfect

Cost and
revenue
SS= all MC

PC MCM
PM

QC QM output
Fig 4. The cases of monopolist reducing price and increasing output

33 | P a g e
Competition (SS) is the sum of the individual firms’ marginal cost curves. Competitive
price is OPc and output OQc. After the industry is taken over by the monopolist, the
monopolist’s marginal cost curve is MCm and lies below the competitive supply curve.
As a result of equating MR with MC, the monopolist will produce the larger quantity
OQm and charge the lower price OPm. It can thus be argued that the monopolization of
the industry benefits the consumer in this instance; the misallocation of resources still
remains, however as price is greater than the new MC.

As mentioned earlier the economies of scale are so large in the cases of some public
utilities that monopoly is the natural production unit. These are described as natural
monopolies. There would clearly be an unnecessary duplication of resources if two gas
companies served the same district with two sets of pipes under each road. In the case of two
separate telephone systems serving the same district, there would be a similar waste of resources
with two sets of cables side by side, and with the added complication that in order to be able to
contact all telephone subscribers, one would need to hire two telephones! With natural
monopolies, the United Kingdom approach has generally been to place them in public
ownership. An alternative approach (more common in the United States) is to allow the existence
of a private monopoly, but to establish a regulatory agency to monitor and control the
monopolist's prices and profits.

(b) Technical progress it has been claimed that the existence of high profits and larger resources
allows the monopolist to devote a large amount of expenditure to research and development.
This may be beneficial to society as it can lead to an increased rate of technical progress and
thus economic growth. The monopolist's position is often more secure than that of a
competitive firm and he is thus able to devote more resources to innovative activity over a
long period.

Schumpeter was a notable proponent of the view that the dynamic gains to society from
monopoly through increased technical progress outweighed the costs of resource misallocation.

34 | P a g e
Whether or not monopoly actually does lead to increased technical progress, however, is not
clear. Studies for the United Kingdom have found no conclusive evidence of a link between the
levels of concentration and the rate of innovative activity.

Monopolistic competition

The model of monopolistic competition was originally developed by E.H. Chamberlin in his
book The Theory of Monopolistic Competition in 1933. The assumptions of the model are
similar to those of perfect competition with one exception. It is assumed that there are a large
number of producers of similar, but differentiated, products. An example might be food retailing
where a large number of competing stores offer a similar range of goods, but differ as regards
location and service. Within the model, there is freedom of entry and exit for firms.

The differentiation of the product offered by individual producers implies that whilst each firm is
likely to face a relatively elastic demand curve, it will not face a perfectly elastic demand curve.
This is because if a single firm should raise its price, it would not lose all of its sales, as would be
the case in perfect competition. Some customers would continue to buy the product because of
the qualities that differentiate it from the competing products. In other words, brand loyalties
exist.

Short-Run Price and Output Determination under Monopolistic Competition

 Figure below shows the price and output determination under monopolistic competition.
Since a monopolistically competitive firm produces a differentiated product that has close
substitutes, the demand curve it faces is negatively sloped but highly price elastic. As in the
case of monopoly, since the demand curve facing a monopolistic competitor is negatively
sloped and linear the corresponding marginal revenue curve is below it.

 The best level of output of the monopolistically competitive firm in the short run is given by
the one at which MR=MC. This is shown by point E0 on the figure (a). The optimal output is
Q1, while the optimal price is P1. The monopolistically competitive firm earns and economic
profit represented by area P1CVA in figure (a).

35 | P a g e
 Short-run and Long-run Price and Output Determination under Monopolistic Competition

Price

Price LMC
LAC
MC

AC
C
P1
P2

A v

E0 E1
AR’
AR=D

MR
MR’

0 Q1 Quantity Q2 Quantity

a) Short-run Equilibrium b) Long-run Equilibrium

Long-Run Price and Output Determination under Monopolistic Competition

If firms in a monopolistically competitive market earn economic profits in the short-run, more
firms will enter the market in the long run. This shifts the demand curve facing each
monopolistic competitor to the left (as its market share decreases) until it becomes tangent to the
firm’s LAC curve. Thus, in the long run all monopolistically competitive firms break even (earn
normal profit) and produce on the negatively sloped portion of their LAC curve (rather than at
the lowest point, as in the case of perfect competition). This is shown in the figure above (b). The
condition to be satisfied for profit maximization in the long run is MR = MC and P =AC.

6.11. Welfare Implications

The model of monopolistic competition clearly does not lead to an optimal allocation of
resources. Price exceeds marginal cost in both the short-run and the long-run. As we noted
above, production in monopolistic competition is conducted above the minimum point on the
LRAC curve. This means that the consumer pays a higher price relative to that paid in the long-
run in perfect
36 | P a g e
Fig 6. 7. Long run equilibrium of a firm in monopolistic competition

competition. This prediction is sometimes called the excess capacity theorem indicating that the
monopolistically competitive firm could achieve lower-cost production if it increased its output.
The consumer has to pay for the wasteful over-provision of capacity through higher price

Oligopoly

Oligopoly is a market structure having few large dominant producers or sellers. Where it exists
each firm knows that its profit depends on its rivals’ action. The unique characteristic with
respect to oligopoly market structure is that one firm’s action will produce a reaction to its
competitors. This is unlike in the case of perfect and monopolistic competitive markets, which
are too small to have a significant impact on other firms.

Take an example of a three-firm oligopoly market. If one firm reduces the price in order to
increase its market share and earn more profit, the other two firms will not ignore it since their
market share or profit will be adversely affected. They will react to protect their interest. This
way the three firms will be interdependent in the market. Therefore, any one taking unilateral
decision regarding price or quantity or anything else will take into account the possible reactions
of its rivals in mind. In most cases the market concentration ratio for largest four firms in the
industry is between 50% and 100% of the total output from the industry.
37 | P a g e
Examples of oligopolistic industries include aluminum processing, motor vehicle assembling,
glass manufacturing, petroleum industry, etc. In each of these industries a small number of firms
produce all or a very large percentage of output.

5.2.3. Oligopoly

We have so far investigated two important forms of market structures: pure competition, where
there are typically many small competitors and pure monopoly, where there is only one large
firm in the market. However, much of the world lies between these two extremes. Often there are
a number of competitors in the market, but not too many as to regard each of them as having a
negligible effect on price. This is the situation known as oligopoly.

There are several models that are relevant since there are several different ways for firms to
behave in an oligopolistic environment. It is unreasonable to expect one grand model since many
different behavior patterns can be observed in the real world. What we want is a guide to some of
the possible patterns of behavior, and some indication of what factors might be important in
deciding when the various models are applicable.

For simplicity, we will usually restrict ourselves to the case of two firms; this is called a situation
of duopoly. The duopoly case allows us to capture many of the important features of firms
engaged in strategic interaction without the notational complications involved in models with a
larger number of firms. Also, we will limit ourselves to investigation of cases in which each firm
is producing an identical product. This allows us to avoid the problems of product differentiation
and focus only on strategic interactions.

5.2.4. Choosing a strategy

If there are two firms in the market and they are producing a homogenous product, then there are
four variables of interest: the price that each firm charges and the quantities that each firm
produces.

38 | P a g e
When one firm decides about its choices for prices and quantities, it may already know the
choices made by the other firm. If one firm gets to set its price before the other firm, we call it
the price leader and the other firm the price follower. Similarly one firm may get to choose its
quantity first, in which case it’s a quantity leader and the other is the quantity follower. The
strategic interactions in this case form a sequential game.

On the other hand, it may be that when one firm makes its choices, it doesn’t know the choices
made by the other firm. In this case, it has to guess about the other firm’s choice in order to make
a sensible decision itself. This is a simultaneous game. Again there two possibilities: the firms
could each simultaneously choose prices or each simultaneously chooses quantities.

This classification scheme gives us four possibilities: quantity leadership, price leadership,
simultaneous quantity setting, and simultaneous price setting. Each of these types of interaction
gives rise to a different set of strategic issues.

There is also another possible form of interaction which we will examine. Instead of the firm
competing with each other in one form or another they may be able to collude. In this case the
two firms can jointly agree to set prices and quantities that maximize the sum of their profits.
This sort of collusion is called a cooperative game.

5.2.5 Quantity leadership

In the case of quantity leadership, one firm makes a choice before the other firm. This is
sometimes called the Stackelberg’s model in honor of the first economist to systematically study
leader-follower interactions.

The stackelberg model is often used to describe industries in which there is a dominant firm, or a
natural leader. For example, IBM is often considered to be a dominant firm in the computer
industry. A commonly observed pattern of behavior is for smaller firms in the computer industry
to wait for IBM’s announcements of new products, and then adjust their own decisions
accordingly. In this case we might want to model the computer industry with IBM playing the
role of stackelberg leader, and the other firms in the industry being Stackelberg followers.

39 | P a g e
Let us now turn to the details of the theoretical model. Suppose that firm 1 is the leader and it

chooses to produce a quantity y1 . Firm 2 responds by choosing a quantity y 2 . Each firm knows
that the equilibrium price in the market depends on the total output produced. We use the inverse

demand function pY  to indicate the equilibrium price as a function of industry output,
Y  y  y2

What output should the leader choose to maximize its profits? The answer depends on how the
leader thinks that the follower will react to its choice. Presumably the leader should expect that
the follower will attempt to maximize profits as well, given the choice made by the leader. In
order for the leader to make a sensible decision about its own production, it has to consider the
follower’s profit maximization problem

5.2.5.1. The follower’s problem

We assume that the follower wants to maximize profits

max p y1  y 2  y 2  c 2  y 2 
y2

The follower’s profit depends on the output choice of the leader, but from the view of the
follower, the leader’s output is predetermined and the production by the leader has already been
made and the follower simply views it as a constant.

The follower wants choose an output level such that marginal revenue equals marginal
cost.

p
MR2  p y1  y 2   y 2  MC2
y 2

The marginal revenue has the usual interpretation. When the follower increases its output, it
increases its revenue by selling more output at the market price. But it also pushes the prices

40 | P a g e
down by p , and this lowers its profits on all the units that were previously sold at a higher
price. The important thing to observe is that the profit maximizing choice of the follower will
depend on the choice made by the leader. We write this relationship as,

y 2  f 2  y1 

The function f 2  y1  tells us the profit maximizing output of the follower as a function of the
leader’s choice. This function is called the reaction function since it tells us how the follower
will react to the leader’s choice of output.

Let’s derive a reaction curve in the simple case of a linear demand. In this case, the (inverse)

demand function takes the form p y1  y 2   a  b y1  y 2  and for convenience we will take
costs to be zero.

Then the profit function for firm 2 is

 2  y1 , y 2   a  b y1  y 2 y 2
 2  y1 , y 2   ay1  by1 y 2  by22

To see these results algebraically, we need an expression for the marginal revenue associated
with the profit function for firm 2. It turns out that this expression is given by,

MR2  y1 , y2   a  by1  2by2

(This is easy to derive using calculus. If you don’t know calculus, you’ll just have to take this
statement on faith.) Setting the marginal revenue equal to marginal cost, which is zero in this
example, we have,

a  by1  2by2  0

Which we can solve to derive firm 2 reaction curve:

a  by1
y2 
2b

41 | P a g e
The leader’s problem

We have now examined how the follower will choose its output given the choice of the leader.
We turn now to the leader’s maximization problem.

Presumably, the leader is also aware that his action influences the choice of the follower.

This relationship is summarized by the reaction function, f 2  y1  . Hence when making its output
choice it should recognize the influence that it exerts on the follower.

The profit maximization problem for the leader therefore becomes

max p y1  y 2  y1  c1  y1 
y1

Such that y2  f 2  y1 

Substituting the second equation into the first gives us.

max p y1  f 2  y1 y1  c1  y1 
y1

Note that the leader recognizes that when it chooses its output y1 , the total output produced will

be, y1  f 2  y1  : its own output plus the output produced by the follower.

When the leader contemplates on changing its output, it has to recognize the influence it
exerts on the follower. Let’s examine this in the context of linear demand curve described above.
There we saw that the reaction function was given by

a  by1
f 2  y1   y 2  ........ i 
2b

Since we have assumed that marginal cost is zero, the leader’s profits are

  y1 , y2   p y1  y2 y1  ay1  by12  by1 y2 .............ii

42 | P a g e
But the output of the follower, y 2 will depend on the leader’s choice via the reaction function
y 2  f 2  y1 

Substituting from equation (i) into equation (ii) we have

  y1 , y 2   ay1  by12  by1 f 2  y1 

a  by1
 ay1  by12  by1
2b

Simplifying this equation gives us

  y1 , y 2  
a b
y1  y12
2 2

The, marginal revenue for this function is

a
MR   by1
2

Setting this equation to marginal cost which is zero in this example, and solving for y1 gives us

a
y1* 
2b

*
In order to find the followers output, we simply substitute y1 into the reaction function

a  by1*
y 
*
2
2b
a

4b

y1*  y 2*  3a
These two equations give a total industry output of 4b

Price leadership

43 | P a g e
Instead of setting quantity, the leader may instead set prices. In order to make a sensible decision
on how to set its price, the leader must forecast how the follower will behave. Accordingly, we
must first investigate the profit maximization problem facing the follower.

The first thing we observe is that in the equilibrium, the follower must always set the
same price as the leader. This follows from our assumption that the two firms are selling
identical products, if one charged a different price than the other, all of the consumers will prefer
the producer with the lower price and we couldn’t have an equilibrium with both firms
producing.

Suppose that the leader has set a price p . We will suppose that the follower takes this
price as given and given and chooses its profit maximizing output. This is essentially the same as
the competitive behavior we investigated earlier. In the competitive model, each firm takes the
price as being outside of its control because it is such a small part of the market; in the price
leadership model, the follower takes the price as being outside its control since it has already
been set by the leader.

The follower wants to maximize profits.

max py2  c 2  y 2 
y2

This leads to the familiar condition that the follower will want to choose an output level where

price equals marginal cost. This determines supply curve for follower, S  p  which is illustrated
below.

44 | P a g e
 Market
Price demand
Follower’s
supply

Demand curve facing

leader (residual demand)

MR facing leader

p*

MC to leader

YL* YT* Quantity

Turn now to the

problem facing the leader; it realizes that if it sets a price p , the follower will supply S  p  . That

means that the amount of output the leader will sell will be R p   D p   S  p  . This is called
the residual demand curve facing the leader.

Suppose that the leader has a marginal cost of production c . Then the profit that it will
achieve for any price p is given by:

 1  p    p  c D p   S  p    p  c R p 

In order to maximize profit the leader wants to choose a price and output combination where
marginal revenue equals marginal cost. However the marginal revenue should be the marginal
revenue of the residual demand curve- the curve that actually measures how much output will be
able to sell at each price. In the graph above, the residual demand curve is linear. Therefore the
marginal revenue curve associated with it will have the same vertical intercept and be twice as
steep.

Let’s look at a simple algebraic example. Suppose that the inverse demand curve is
2

D p   a  bp . The follower has a cost function c2  y 2   y 2

2 and the leader has a cost function

c1  y1   cy1 .
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 For any price p the follower wants to operate where price equal marginal cost. If the
y 22
c2  y 2  
cost function is 2 , it can be shown that the marginal cost curve is MC2  y2   y2 .
Setting price equal to marginal cost gives us

p  y2

Solving for the follower supply curve gives y 2  S  p   p

The demand curve facing the leader-the residual demand curve is

R p   D p   S  p   a  bp  p  a  b  1 p.

From now on this is just like an ordinary monopoly problem. Solving for p as a function of the

leader’s output y1 we have

a 1
p  y1 .
b 1 b 1

This is the inverse demand curve facing the leader. The associated marginal revenue curve has
the same intercept and is twice as steep. This means that it is given by

y1 .......... .i 
a 2
MR  
b 1 b 1

Setting marginal revenue equal to marginal cost gives us the equation

a 2
MR   y1  c  MC
b 1 b 1

Solving for the leader’s profit maximizing output, we have

a  cb  1
y1* 
2

We could go on and substitute this into equation (i) to get the equilibrium price, but the equation
is not particularly interesting.
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Comparing price leadership and quantity leadership.

We have seen how to calculate the equilibrium price and output in the case of quantity
leadership. Each model determines a different equilibrium price and output combination; each
model is appropriate in different circumstances.

One way to think about quantity setting is to think the firm as making capacity choice.
When a firm sets a quantity, it is in effect determining how much it is able to supply to the
market. If one firm is able to make an investment in capacity first, then it is naturally modeled as
a quantity leader.

On the other hand, suppose that we look at a market where the capacity choices are not
important but one of the firm distributes a catalogue of prices. It is natural to think of this firm as
the price setter. Its rivals may then take the catalogue price as given and make their own pricing
and supply decisions accordingly.

Whether the price leadership or the quantity leadership is appropriate is not a question
that can be answered in pure theory. We have to look at how the firms actually make their
decisions in order to choose the most appropriate model.

Question

Consider an industry with two firms each having marginal cost equal to zero. The inverse

demand curve facing this industry is p y   100  y . Where y  y1  y2 . Determine the

Stackelburg equilibrium.

Simultaneous Quantity Setting

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One difficulty with the leader follower model is that it’s necessarily asymmetric: one firm is able
to make its decision before the other firm. In some situations, this is unreasonable. e.g. suppose
that two firms are simultaneously trying to decide what quantity to produce. Here each firm has
to forecast what the other firm’s output will be in order to make a sensible decision itself.

We will examine a one period model in which each firm has to forecast the other firm’s output
choice. Given its forecast, each firm then chooses a profit maximizing output for itself. We then
seek equilibrium in forecast-a situation where each firm finds it believes about the other firm to
be confirmed. This model is known as the Cournot model, after the 19th century, French
mathematician who first examined its implications.

e
We begin by assuming that firm 1 expects that firm 2 will produce y 2 units of output. (The e

stand for expected output) if firm 1 decides to produce y1 units of outputs, it expects that the total

output produced will be Y  y1  y 2 and output will yield a market price of pY   py1  y 2  .
e e

The profit maximization problem of firm 1 is then,

 
max p y1  y 2e y1  c y1 
y1

e
For any given believe about the output of firm 2, y 2 there will be some optimal choice of

output for firm 1, y1 . Let us write this functional relationship between the expected output of firm
2 and the optimal choice of firm 1 as

 
y1  f1 y 2e

This function is simply the reaction function that we investigated earlier in this chapter.
On our original treatment, the reaction function gave the follower’s output as the function of the
leader’s choice. Here the reaction function gives one firm’s optimal choice as a function of it’s
believes about the other firm’s choice. Although the interpretation of the reaction function is
different in the two cases, the mathematical definition is exactly the same. Similarly, we can
derive firm 2’s reaction curve
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  
y 2  f 2 y1e

e
Which gives firm 2’s optimal choice of output for a given expectation about firm 1’s output y1

Now, recall that each firm is choosing its output level assuming that the other firm’s
e e e e
output will be at y1 or y 2 . For arbitrary values of y1 and y 2 , this won’t happen-in general firm
e
1’s optimal level of output, y1 will be different from what firm 2 expects the output to be y1 .

*
 *

Let us seek an output combination, y1 , y 2 such that the optimal output level for firm 1,
* *
assuming firm 2 produces y 2 , is y1 and the optimal output level for firm 2, assuming that firm 1
* *
*

*
stays at y1 is y 2 . In other words, the output choices y1 , y 2 satisfy

 
y1*  f 1 y 2*
y 2*  f  y .
2
*
1

Such a combination of output levels is known as Cournot equilibrium. In a Cournot

equilibrium, each firm is maximizing its profits, given its believes about the other firms output
choice and, further more, those believes are confirmed in the equilibrium: each firm optimally
chooses to produce the amount of output that the other firm expect it to produce. In a Cournot
equilibrium, neither firm will find it profitable to change its output once it discovers the choice
actually made by the other firm.

The Cournot equilibrium is simply the pair of output at which the two reaction curves
cross. At such a point, each firm is producing a profit maximizing level of output given the
output choice of the other firm.

An example of Cournot equilibrium.

Recall the case of the linear demand function and zero marginal cost that we investigated earlier.
We saw that in this case, the reaction function for firm 2 took the form,

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 a  by1e
y2 
2b

Since in this example firm 1 is exactly the same as firm 2, its reaction curve has the same form

a  by2e
y1 
2b

The graph below depicts this pair of reaction curves. The intersection of the two lines gives us
the Cournot equilibrium. At this point each firm’s choice is the profit maximizing choice, given
its beliefs about the other firm’s behavior, and each firm’s beliefs about the other firm’s behavior
are confirmed by its actual behavior.

In order to calculate the Cournot equilibrium algebraically, we look for the point  y1 , y 2  where

each firm is doing what the other firm expects it to do. We set y1  y1 and y 2  y 2 which gives
e e

us the following two equations in two unknowns.

a  by2
y1 
2b
a  by1
y2 
2b

In this example, both firms are identical, so each will produce the same level of output in

equilibrium. Hence we substitute y1  y 2 into one of the above equations to get

a  by1
y1 
2b

a
* y1* 
Solving for y1 , we get 3b

Since the two firms are identical, this implies that

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 a
y 2* 
3b

as well and the total industry output is.

2a
y1*  y 2*  .
3b

Simultaneous price setting

In the Cournot model described above, we have assumed that firms were choosing their
quantities and letting the market determine the price. Another approach is to think of firms as
setting their prices and letting the market determine the quantity sold. This model is known as
Bertrand competition.

When a firm chooses its price, it has to forecast the price set by the other firm in the
industry. Just as in the case of Cournot equilibrium, we want to find a pair of prices such that
each price is a profit maximizing point given the choice made by the other firm.

What does Bertrand equilibrium look like? When firms are selling identical products, as
we have been assuming, the Bertrand equilibrium has a very simple structure in deed. It turns out
to be the competitive equilibrium, where prices equal marginal cost.

First we note that price can never be less that marginal cost since then either firm would
increase its profits by producing less. Let us consider the case where price is greater than

marginal cost. Suppose that both firms are selling output at some price p̂ greater than marginal
cost. Consider the position of firm 1. If it lowers its price by any small amount e , and the other

firm keeps its price fixed at p̂ , all the consumers will prefer to purchase from firm 1. By cutting
its price by an arbitrary small amount, it can steal all the customers from firm 2. If firm 1 really

believes that firm 2 will charge a price p̂ that is greater than marginal cost, it will always pay

firm 1 to cut its price to pˆ  e . But firm 2 can reason the same way! Thus any price higher than
marginal cost cannot be an equilibrium; the only equilibrium is competitive equilibrium.
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 This result seems first paradoxical when you first encounter it: how can we get a
competitive price when there are only two firms in the market? If we think of Bertrand model as
a model of competitive bidding, it makes more sense. Suppose that one firm ―bids‖ for the
customers business by quoting a price above marginal cost. Then the other firm can always make
a profit by undercutting this price by a lower price. It follows that the only price that each firm
cannot rationally expect to be undercut is the price equal to marginal cost.

It is often observed that competitive bidding among the firms that cannot be able to
collude result in prices that are much lower than can be achieved by other means. This
phenomenon is simply an example of logic of Bertrand competition.

6.4. Collusion

In the model, we have examined up until now the firms have operated independently. But if the
firms collude so as to jointly determine their output, these models are not reasonable. If collusion
is possible, the firm would do better to choose the output that maximizes total industrial profit
and then divide up the profits among them. When firms get together and attempt to set a price so
as to maximize total industrial profit, they are known as cartels. A cartel is simply a group of
firms that jointly collude to behave like a single monopolist and maximize the sum of their
profits.

Thus the profit maximization problem facing the two firms is to choose their outputs y1

and y 2 so as to maximize total industry profits.

max p y 1  y 2  y1  y 2   c1  y1   c 2  y 2 
y1 , y 2

This will have the optimality conditions

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 
p y1*  y 2* p *
Y
 
y1  y 2*  MC1 y1*  

p y1*  y 2* p *
Y
 
y1  y 2*  MC 2 y 2* 

The interpretation of these conditions is a interesting. When firm 1 considers expanding its

output by y1 , it will contemplate the usual two effects: the extra profits from selling more
output and the reduction in profits from forcing the prices down. But in the second effect, it now
takes into account the effect to the lower price both its own output and the output of the other
firm. This is because it is now interested in maximizing total industry profits, not just its own
profits.

The optimality conditions imply that the marginal revenue of an extra unit of output must

be the same no matter where it is produced. It follows that, MC1 y1   MC 2 y 2  , so that the two
* *

marginal costs will be equal in equilibrium. If one firm has a cost advantage, so that it’s marginal
cost curve always lie below that of the other firm, then it will necessarily produce more output in
equilibrium in the cartel solution.

The problem with agreeing to join a cartel in real life is that there is always a temptation
to cheat. Suppose, e.g. that the two firms are operating at the output that maximize industry

profits  y1 , y 2  and firm 1 considers producing a little more output, y1 the marginal profit
* *

accruing to firm 1 will be,

 1 p *
y1

 p y1*  y 2* 
Y

y1  MC1 y1*  

We saw earlier that the optimality condition for the cartel solution is,

p * p *
 
p y1*  y 2* 
Y
y1 
Y
 
y 2  MC1 y1*  0

Rearranging this equation gives us.

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 p * p *
 
p y1*  y 2* 
Y
 
y1  MC1 y1*  
Y
y2  0

p
The last inequality follows since Y is negative, since the market demand has a negative
slope.

Inspecting the above equations, then we see that

 1
0
y1

Thus if firm 1 believes that firm 2 will keep its output fixed, then it will believe that it can
increase profits by increasing its own production. In the cartel solution the firms act together to
restrict output so as not to ―spoil‖ the market. They recognize the effect of joint profits from
producing more output in their firms. But if each firm believes that the other firm will stick to its
output quota, then each firm will be tempted to increase its profits by unilaterally expanding its
outputs. At the output level that maximize joint profits, it will always be profitable for each firm
to unilaterally increase in output-if each firm expects that the other firm will keep its output
fixed. The situation is even worse than that. If firm 1 believes that firm2 will keep its output
fixed, then it will find it profitable to increase its own output. But if it thinks firm 2 will increase
its own output, then firm 1 would want to increase its output first and make profits while it can.

Thus, in order to maintain an effective cartel, the firms need a safe way to detect and
punish cheating. If they have no way to observe each others output, the temptation to cheat may
break the cartel.

To make sure that we understand the cartel situation, let’s calculate it for the case of zero
marginal cost and the linear demand curve we used in the Cournot’s case.

The aggregate profit function will be

  y1 , y2   a  b y1  y2  y1  y2   a y1  y2   b y1  y2 2

So the marginal revenue equals marginal cost conditions will be,

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  
a  2b y1*  y 2*  0

This implies that,

a
y1*  y 2* 
2b

Since marginal costs are zero, the division of output between the two firms doesn’t matter. All
that is determined is the total level of industry output.

Comparison of the solutions

We have now examined seven models of duopoly behavior: quantity leadership (Stackelberg’s),
price leadership, simultaneous quantity setting (Cournot’s), simultaneous price setting (Bertrand)
and the collusive solution. How do they compare?

In general, collusion results in the smallest industry output and the highest price. Bertrand
equilibrium- the competitive equilibrium- gives us the highest output and the lowest price. The
other models give results that are in between these two extremes.

A variety of other models are possible. e.g. we could look at a model with differentiated
products where the two goods produced were not perfect substitutes for each other. Or we could
look at a model where the firms make a sequence of choices over time. In this framework, the
choices that one firm makes at one time can influence the choices that the other firm makes later
on.

We have also assumed that each firm knows the demand functions and the cost functions
of the other firm in the industry. In reality, these functions are never known for sure. Each firm
needs to estimate the demand and cost conditions facing its rivals when it makes its own
decisions. All of these phenomena have been modeled by economists, but the models become
much more complex.

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 Note

Collusion results in the smallest industry output and the highest price. The competitive

equilibrium gives the highest output and the lowest price. All other models give results that are

in between these two extremes.

Question

From question in the previous lesson, determine the Cournot equilibrium and the cartel amount

of output.

Activity

Identify a real world market that resembles the cartel structure and examine its characteristics.

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