Chapter 10

Monopolistic Competition and

Oligopoly

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 Features of monopolistic
Competition
• Large number of sellers but each seller is a
Price Maker
• Large number of imperfect substitutes due to
product differentiation
• Large number of uninfluencing buyers – both
informed and uninformed
• Free entry

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 DETERTMINATION OF SHORT TERM
AND LONG RUN EQUILIBRIUM

MC
AVC

D
MR
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 DETERTMINATION OF SHORT TERM
AND LONG RUN EQUILIBRIUM

MC
AVC

MRL DL D
MR
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 PROFIT IN LONG RUN

PROFIT

NUMBER OF FIRMS
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 Equilibrium- Short run and Long
run
• In the Short run at MR =MC , the seller
makes Super normal Profits
• In the Long run, ‘ Free entry’ squeezes
out the Profit
• So at the Long run equilibrium, MR =
MC= AC

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Normative analysis of Monopolistic
Competition
• Long run equilibrium at Price=AC=MC
BUT
With demand curve being downward sloping, AC
is not at its minimum.
Therefore inefficiency and excess capacity.
* With free entry and product differentiation,
variety is available.

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 Features of Oligopoly

• Few sellers
• Interdependence
• Intense rivalry
• ‘Strategy’ plays a dominant role.
• Barriers to entry; Natural and Strategic

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 Equilibrium in Oligopoly

• Cournot Equilibrium
• Bertrand Equilibrium
• Stackelberg Equilibrium
• The kinked demand model
• Cartel
• Collusion
• Price Leadership

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 Equilibrium in Oligopoly
MARKET DEMAND FACED BY HERO AND ATLAS

PRICE
500

400

300

200

100

0 100 200 300 400 500 600 700 800 900

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 Cournot equilibrium
• Special case of Duopoly
• Passive players
• Identical firms
• MC is identical, constant and assumed to
be equal to zero.

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 Cournot equilibrium
• Demand Equation for the product Q
P = 12-Q
where Q = q1 + q2
So P =12-q1- q2
TR 1 = q1((12 –q2) – q1)
MR 1 = 12- q2 – 2q1
Equating to MC = 0, we get
q1 = (12-q2) / 2---Reaction curve

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 Cournot equilibrium
• Similarly Reaction function of firm 2:
q2 = (12-q1) /2
Solving these two simultaneously, gives:
q1 = 4 and q2 = 4
Graphically this is the point of intersection
of the Reaction curves.
This is the Cournot equilibrium

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 Case 1
• a) The roll preparation involves two variable cost
components: (i) the center filling
• (ii) Ten minutes of labour
• So, we have 4Q + 1Q = 5Q.
• c) Cournot players:
• TC = 5Q
• MC = 5
• Q = 100 – P or P = 100-Q
• P = 100-(q1+q2) = 100-q1-q2
• TR1=PXq1=(100-q1-q2)q1 = 100q1-(q1)2 –q1xq2
• MR1 = TR1/ q1=100-2q1-q2
• MC = 5

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 Case 1
• MR1 = TR1/ q1=100-2q1-q2
• MC = 5
• MR1=MC1 = 100-2q1-q2 = 5
• q1=100-5-q2 = 0=(95-q2-2q2)… Equilibrium for firm 1
• FOR FIRM 2
• TR2=PXq2=(100-q1-q2)q2 =100q2-(q2)2 –q1xq2
• MR2 = TR2/ q2=100-2q2-q1
• MC = 5
• MR2=MC2= 100-2q2-q1=5 =95-2q2-q1
• Solve 95-2q1-q2=0 ……1
• 95-q1-2q2=0…….2 (x2) and subtract
• 190-2q1-4q2 =0....2
• 95-0-3q2=0, q2=95/3=32, smiliarly 32 for other also.(rounded)

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 Case 1

• Deriving the reaction curves and solving for q1 and q2,

we get q1 = 32, q2 = 32.
• The total Q = 64, and P = 36.

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 BERTRAND EQUILIBRIUM
• b) Bertrand players will keep cutting prices
till price equals cost. So they will be
• selling at the price of Rs.5.
• Q = 100 – 5 = 95 units in all.

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 Bertrand Equilibrium
• Two identical firms
• Sequential reaction.
• First, firm 1 cuts price below the going
price to grab the entire market share
• Second firm retaliates
…….This goes on till
P = MC …… Bertrand Equilibrium

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 Stackelberg Equilibrium
• Leader – follower
• Leader-Firm1- expresses demand equation
in terms of q1.
How?
Incorporates firm 2’s reaction equation for
q2 in the demand equation:
P = 12 – q1 – ((12-q1)/2)
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 Stackelberg Equilibrium
• Derive TR1, MR1.

• Equate to MC and solve for q1.

• Solve for q2 = (12-q1) / 2
• q1 = 6 ; q2 = 3

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 Kinked demand hypothesis
• Paul Sweezy:

P The stretch PE is elastic – no incentive to raise prices

The stretch EQ is inelastic-no incentive to cut prices

E

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 Cartels
• Objective: to raise the price to an artificial
high.
• Agree on a high price by restricting supply
• Inherently fragile because of the incentive
to ‘chisel’.
• So cartels break down.

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 Collusion
• Conditions that favour collusion:
- fewer rather than larger number of firms
- Lesser differences in costs rather than greater
- steady demand rather than variations in demand
- easier to detect cheating rather than …..
- More homogeneity in product rather than
heterogeneity

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 Price leadership
• Dominant price leadership

• Barometric price leadership

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 Dominant price leadership

MC

D
MR

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 Barriers to entry
• Structural entry Barriers and strategic entry
barriers
• Sources:
Control over critical inputs
Absolute cost advantage
Economies of scale
Product differentiation
Preemption of Product and geographic space

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 Game Theory and Oligopoly
• A Pay off Matrix: WIPRO
without remote with remote
without areas areas
H remote areas 40,70 35,55
C
L With remote
areas 30,60 45,45

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 A Game Tree
Rs 4000,4000
high
Atlas
Rs 6000,1000
high low
Hero low high
Rs 1000,6000
Atlas
low

Rs 3000,3000

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 Strategies

• Maximin Strategy
• Dominant Strategy
• Dominated Strategy
• Pure and mixed Strategy

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 Dominant Strategies
• Dominant Strategy:
Firm 2
no Price change Price change
no price change 10,10 140,30
Firm1

Price change -20,20 100,25

The dominant strategy for firm 1 is no price change.
The dominant strategy for firm 2 is price change

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 Dominated strategies
• incumbent firm
block cut price increase
entry capacity
Entrant enter 2 6 14
single
enter jointly 8 7 10
This is the payoff of the entrant-increase in market share,
where, total market size is constant .
Increase capacity is dominated strategy for incumbent.

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 Maximin strategies
• Firm 2
introduce donot introduce
new product new product
Firm1 introduce 2,2 6,3

do not introduce 3,6 4,4

Maximin strategy for firm1 is donot introduce.
Maximin for firm 2 is do not introduce.

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 Different Games
• Entry Game
• Games of imperfect and incomplete
information – Prisoners’ Dilemma
Games
• Sequential Games
• Repeated Games
• Finitely repeated Games

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 Entry Game
-2lakhs, +5lakhs

High output
Indian
Low output
+6 lakhs, +6lakhs
enter
Jet 0 lakhs, +12 lakhs
Stay out high
Indian
low

0 lakhs, +8 lakhs

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 Prisoners’ Dilemma
• Prisoner 2
confess don’t confess
confess -20,-20 -5,-25
Prisoner1
don’t confess -25,-5 -10,-10

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 Sequential games
• Games of first mover advantage:
firm 1
chocolate natural
chocolate -10,-10 20,15
Firm2
natural 15,20 -10,-10

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 Sequential games
• First mover advantage: New Product Introduction
firm 1
Introduce Do not introduce
Introduce -5, -5 10, 3
Firm2
Do not introduce -3 ,10 3, 3

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