Monopolistic Competition

and Basic Oligopoly Models

Monopolistic Competition
(Chamberlin Model)
Free entry, many firms sell (physically
or perceivably) differentiated products.
Firms ignore competitors. Each redefines
market to a segment (consumers preferences)
& estimates its own downward demand d.
Other brands make firms demand d more
elastic (for segment only) than market share
curve M (for entire market). Firms market
power limited, but still allows P > MC.
In short run firm may move along d, but
eventually similar conditions lead to similar
P: each firm operates at d & M intersection.
Equilibrium when firms re-estimated
d intersects M where SMC = MR.

Monopolistic Competition in the Log-Run

The Good
(for Consumers):
Product Variety

Long Run Equilibrium

(P = AC, so zero profits)

The Bad
(for Society):
P*
P > MC =>
P1 = AC1
Inefficiencies
AC*
& Misallocations
The Ugly
(for Managers):
Free Entry drives
Long Run Profit
to Normal = 0

MC
AC

Entry
MR
Transitory
Total Profit

Q1 Q*

MR1

D1
Quantity of Brand
X

Strategies to Avoid (or Delay)

the Zero Profit Outcome
Change; dont let the long-run set in.
Be the first to introduce new brands or to
improve existing products and services.
Seek out sustainable niches.
Create barriers to entry.
Increase the time it takes others to clone your
brand with trade secrets and strategic plans.

Oligopoly
Few sellers (< 10, 2 in duopoly) of homogeneous or differentiated product actively competing for
market share.
Barriers to entry:
Entry limiting pricing P < P* and Market saturation: discourage entry
Fed Trade Commission antitrust against General Mills, General Foods
& Kellogg for proliferation of brands (fill shelves & prevent entry)

Excess capacity (econ of scale) & reputed P retaliation: P cutting

In 1971 Proctor & Gamble (west cost) promoted (advertisement & P)
its Folger in Pitt & Cleveland (General Foods Maxwell House turf).
GF lowered P & started promoting in midwest (shared turf).
GFs 30% in 1970, 30% in 1974. After PG retreated P & recovered.

Capital requirements
Product differentiation, hard for entrant to attract customers

Strategic Interaction
What you do affects the profits of your rivals
What your rival does affects your profits

Strategic Interdependence
Firm is not in
complete control
of its own destiny.
Change in firms
quantity demanded
depends on whether
rivals match firms
change in price!

D2 (Rivals match your

price change)

PH

D (Rivals match your

price Reductions but
not price Increases)

P0
PL

Q0

D1 (Rivals hold
their price
constant)
Q

Sweezy (Kinked
Demand) Model
Few firms in the market
(entry barriers) produce
differentiated products.
Each firm believes rivals
match price reductions,
but not price increases.
Key feature: Price-Rigidity
( cost firms operate at kink)
With econ wide increase
in production costs, firm
might profitable increase
price, regardless of others.
When others follow adjust
d upward to new kink Q3,P2

M = DMarket

MCH
MC
MCL

PK
MRM

d = DFirm
MRd
QK

MR

D
Q

Sweezy Model: An Example

P = 10, TC = 1500 + 3Q + 0.0025Q2
Consultant QM = 1500 - 50P
and Qd = 3000 - 200P
Qk = 1000
At kink: Pk = 10 and
QM = 1500 - 50P = 3000 - 200P = Qd
Vertical gap in MR (at Qk= 1000):
MRM = 30 - 0.04*1000 = -10
MRd = 15 - 0.005*1000 = 5 < MC
MC = 3 + 0.005*1000 = 8
max: MRF -MC = 0 =>
QF = 800, PF = 11
Qk = 3000

<

Q* = 3300

Cournot Duopoly
Two firms produce homogenous product in an
industry with barriers to entry
Firms maximize profit by setting output, as
opposed to price
Each firm wrongly believes their rival will hold
output constant if it changes its own output
Firms reaction (or best-response) function: profit
maximizing amount of output for each quantity of
output produced by rival

Cournots Costless Duopoly

50

Cournot Equilibrium
Each firm produces the profit maximizing output, given the output of rival firms
No firm gains by unilateral changes in its output
Assume:
P = 950 - (Q1 + Q2) and MC = 50
P = a - b(Q1 + Q2) and MCi = Ci

max: MRi = 950 - 2Qi - Qj = 50 = MC

MRi = a - 2bQi - bQj = Ci
Qi = r(Qj) = 450 - 0.5Qj
Qi = r(Qj)= (a-Ci)/2b - Qj/2
Q1 = Q2 = 300

Simultaneously
solved:

Perfect competition: P = MRT = 950 - QT = 50 = MC => QT = 900

Duopoly:
Q1 = Q2 = 300 & 300 unserved
Qn = Qpc[n/(1+n)], where n = # of firm in oligopoly

Cournot Equilibrium
Q1* maximizes firm 1s profits, given that firm 2 produces Q2*
Q2* maximizes firm 2s profits, given that firm 1 produces Q1*
No firm has an incentive to change output, given rivals output
Beliefs are consistent:
In equilibrium, each
firm thinks rival
will stick to current
output - and they do!

Q2
r1 (Firm 1s Reaction Function)
Q2

Cournot Equilibrium

Q2 *
r2

Q1

Q1M

Q1

Bertrand and Edgeworth Duopoly

Two firms produce identical products at constant MC,
in an industry with barriers to entry
Each firm independently sets its profit maximizing price
Consumers have perfect knowledge & no transaction costs
Suppose MC < P1 < P2
Firm 1 earns (P1 - MC) per unit and firm 2 earns nothing
Firm 2 undercuts firm 1s price to capture the entire market
Firm 1 then undercuts firm 2s price
Undercutting continues until equilibrium: P 1 = P2 = MC
Perfect competition profit maximizing solution P = MC
possible with few firms and severe price competition
If duopolists have limited capacity relative to the Bertrand
equilibrium, Edgeworth argued that price will not be stable

Chamberlin Duopoly
Chamberlin applied results from his analysis of monopolistic
competition on oligopoly
Cournot, Bertrand and Edgeworth models assume that
competitors are extremely nave
Chamberlin argued that oligopolists would recognize their
mutual or strategic interdependence and engage in tacit or
informal collusion: independently choose monopoly price and
split profits
Managers signal to competitors their desire not to engage
in destructive price war by setting price
Agreements are not necessary because firms realize any other
strategy is less profitable
Formal Collusive agreements are illegal, although U. S. firms
have been permitted to agree on export pricing

Price Leadership by an Efficient Firm

If duopoliests split
market demand D
equally, each faces
D and MR.
Firm A with the
lowest per unit
costs sets Pa
that firm B is
forced to follow.
Firm B maximizes
profit at Pb, but
adjusts to Pa to
preserve market
share.

Price Leadership by a Large Firm (U.S. Steel)

Small competitors accept large firms profit maximizing P as in perfect
competition and maximize profit where PL(=PS=MRS)=QS(=MCS).
QL=QM-QS=1403-2.6P-(0.9P+150)=1253-3.5P.
MRL=1253-7P=260=MCL => QL*=171.5 (QS=428.7) & PL=PM=309.

Perfect Collusion: The Cartel

Monopoly against world. Max profit: Pcartel>MRcartel=MCmembers
Production allocated inside with MC rule: MRcartel=MCA==MCn
(Ideal that lowest unit cost member has the highest Q & profit is
sometimes modified in short run to maintain unity)
Assume Q=1660200P. Set MR=8.3-.001Q=.305+.000508Q=MC
(MCA=.15+.00015QA, MCB=.60+.0002QB & MCC=.25+.000125QC)
and solve for QT=5300, P=5.65 and MR=3.
Set MR=3=MCi and solve for allocations: QA=1900, QB=1200 & QA=2200

Contestable Markets
Few sellers but free entry: Oligopoly will price at a
perfect competition level & have only normal = 0
Key Assumptions
Producers have access to same technology
Consumers respond quickly to price changes
Existing firms cannot respond quickly to entry by
lowering price
Absence of sunk costs

Key Implications
Threat of entry disciplines firms already in the market
Incumbents have no market power, even if there is only a
single incumbent (a monopolist)

Summary
Different oligopoly scenarios lead to different
optimal strategies and different outcomes
Your optimal price and output depends on
Beliefs about the reactions of rivals
Your choice variable (P or Q) and the nature of the
product market (differentiated or homogeneous
products)
Your ability to commit