Monopolistic Competition and Oligopoly

Tarun Jain

Economics Area

Indian Institute of Management Ahmedabad

Market Competition

In commodities industries like oil, cement and sugar, building

capacity is difficult and expensive. Prices are determined by
the market while firms compete in capacity.

In technology-intensive industries, firms realize large gains

from being first-movers into unexplored markets.

In consumer industries like retail gas, food, capacity is

relatively inexpensive, so firms compete on price.

In the FMCG and clothing industries, goods are very similar,

and firms compete on both price, and features.

The objective of this session is to analyze different types of

oligopoly markets, and firms’ strategic behavior within these.
Oligopoly Markets

I Very few examples of perfectly competitive markets

I Most true monopolies are government mandates

Ex: Railways, National defense, Police etc.
I Market price and structure is less important

⇒ Most actual markets have a few firms competing with each other
with similar products
Oligopoly

Definition
An oligopoly is a market with a small number of firms which is
I Protected by barriers to entry such as government fiat, economies of
scale or control of strategic resources
I Characterized by interdependence, i.e., managers explicitly consider
reactions of rivals
Different ways to compete in oligopoly markets

I Cournot competition
I Compete in capacities, with simultaneous moves

I Stackelberg competition
I Compete in capacities, with sequential moves

I Bertrand competition
i. Compete in prices, without product differentiation
ii. Compete in prices, with product differentiation

I Dominant firm competition

I Dominant firm sets prices, followed by fringe
Competition in Capacity

I In commodities businesses, capacity is very expensive to set up

I Oil rigs and refineries
I Aluminium plants
I Hydro-power (dams)
I New drug development

I Prices are market-determined

I Firms are price-takers
I An oil rig cannot easily shut down production
I Hydro power production responds to reservoir levels, not
market conditions

⇒ Firms have to make critical decisions on capacity

Cournot Competition

Definition
In Cournot competition, two or more firms compete by simultaneously
determining the amount of output they will produce and supply at a
market determined price.
Cournot Competition
I More than one firm

I Fixed number of firms

I Firms compete in capacity

I Make capacity decisions before they enter the market
I Choose quantities simultaneously

I All firms produce homogeneous product

I Firms do not cooperate (No collusion)

I Each firm’s output decision affects price

I Firms have market power

I Firms are economically rational

I Seek to maximize profit given their competitors’ decisions
Duopoly

Definition
A duopoly is a market with only two sellers.

Example
I Colas (Coca Cola and Pepsi)
I Wide-body jets (Airbus and Boeing)
I Bank-issued credit cards (Mastercard and Visa)
I Political parties in the US, Germany, Israel and Japan
Cournot Competition in the Cement Industry

I Market demand curve

I Q = 5 − P(Q)

I Two firms: ACC and JK Cement

I ACC’s marginal cost of production is Rs. 1 per unit (MCA )
I JK Cement’s marginal cost of production is Rs. 2 per unit
(MCJ )
I Q = qA + qJ
I Compete in capacity, not price

I What will happen in this market?

I What is each firm’s production?
I What is market price?
I What are the profits earned by each firm?
Cournot Competition in the Cement Industry

I Analysis for ACC

I TRA = qA ∗ P = qA ∗ (5 − qA − qJ )
⇒ MRA = 5 − 2qA − qJ
I Set MRA = MCA
⇒ 5 − 2qA − qJ = 1
⇒ 2qA = 4 − qJ

I Analysis for JK Cements

I TRJ = qJ ∗ P = qJ ∗ (5 − qA − qJ )
⇒ MRJ = 5 − qA − 2qJ
I Set MRJ = MCJ
⇒ 5 − qA − 2qJ = 2
⇒ qA = 3 − 2qJ
Best Response Function

Definition
A firm’s best response (or reaction) function is its profit maximizing
action as a function of actions by the rival firm(s).
Cournot Competition in the Cement Industry
Best response functions
Cournot Competition in the Cement Industry
Best response functions
Cournot Competition in the Cement Industry
Production, market price and profits for each firm

I Solve two linear equations in two variables

I 2qA = 4 − qJ
I qA = 3 − 2qJ

I Solution
I qA∗ = 5/3
I qJ∗ = 2/3
⇒ Q ∗ = qA∗ + qJ∗ = 7
3
⇒ P ∗ = 5 − 73 = 83

I Firms’ profits
I ACC’s profits = qA∗ (P ∗ − MCA ) = 53 ( 83 − 1) = 25
9
I JK Cement’s profits = qJ∗ (P ∗ − MCJ ) = 32 ( 83 − 2) = 4
9
N-firm Cournot Oligopoly

I Q = q1 + q2 + . . . + qn
I Set MRi = MCi for each firm i
I Solve

I What happens to qi∗ as n increases?

I What happens to market quantity, Q, as n increases?
I What happens to market price, P, as n increases?
I What happens to firm profits, Πi , as n increases?
I What happens to consumer welfare as n increases?
I What happens to social welfare as n increases?
Stackelberg Model of Competition

Definition
In Stackelberg competition, one firm acts as a capacity leader,
choosing its quantity first, with all other firms acting as followers, making
quantity decisions after the leader has moved.
I The Stackelberg model explains “first-mover advantage” in market
entry
Stackelberg Competition
Firms sequentially make capacity decisions

I DRAM market
I Samsung acts as a Stackelberg leader and LG is a Stackelberg
follower

I Analysis
I First consider follower’s profit-maximization problem
I LG observes quantity chosen by leader (qS ) and chooses
quantity (qS ) to maximize profit
I Next consider leader’s profit-maximization problem
I Samsung will solve LG’s problem and choose qS to maximize
profits
Source: Adapted from Besanko and Braeutigam’s Microeconomics textbook.
Stackelberg Competition
Analysis
Stackelberg Competition
Analysis

I Market demand curve

I P = 100 − qS − qL
I Market values products from each firm the same

I MCS = MCL = 10 (no cost advantage for either firm)

I LG’s reaction function is qL = 45 − qS
2 (Work it out!)

I Demand curve for Samsung: P = 100 − qS − (45 − qS

2 )
⇒ MRS = 55 − qS
I Set MRS = MCS
I Solve as qS = 45
I qL = 22.5
I P = 32.5
Stackelberg Model of Competition
Stackelberg vs. Cournot

I These results are different from simultaneous decision Cournot

model

I Profits for Stackelberg leader are greater, and Stackelberg follower

are lower, compared to Cournot outcomes

I Advantage to being a Stackelberg leader (i.e. first to market), but

not as great as being a monopolist (i.e. barriers to entry are
valuable too!)
Bertrand Competition in Colas

Image source: Company websites.

Bertrand Competition

Definition
In Bertrand competition, two or more firms compete by
simultaneously setting prices. Each firm is committed to provide
consumers with the quantity of the firm’s product they demand
given these posted prices.
Bertrand Competition in Colas
Bertrand Competition in Colas
Bertrand Competition in Colas

I Firms price at marginal cost

I Firms do not make profits
Bertrand Competition
Different Marginal Cost Curves
Algorithmic Price Fixing?

Source:

https://www.economist.com/finance-and-economics/2017/05/06/price-bots-can-collude-against-consumers
Manhattan Pizza War
Solutions to Bertrand Paradox

I Capacity constraints
I Compete on capacity as well as price

I Temporal dimension
I Firms enter market sequentially

I Product differentiation
I Create new markets where each firm has monopoly power over
customers

I Collusion
I Collude to earn monopoly profits
I Post-collusion distribution of profits
Bertrand Competition with Product Differentiation

I In most markets, competing products are slightly different from

each other

I Vertical product differentiation

I Consumers have the same ordinal preferences, but not the
same cardinal preferences
Ex. All consumers want cars with better fuel efficiency, but their
willingness to pay differs

I Horizontal product differentiation

I Consumers differ in their preferences along one dimension of a
good
Ex. Some consumers prefer hot salsa, others prefer mild
Bertrand Competition with Product Differentiation

I Firms seek to be unique along some dimension that is valued by

consumers.
I Differentiation can be based on product itself, delivery system,
or marketing approach.

I If firm or product is unique in some respect, then firm can command

price greater than cost.
The Beer Industry

Image source: Company websites.

Bertrand Competition with Product Differentiation
Analysis of the beer industry

I Two products: Carlsberg and Kingfisher

I Each beer is slightly different from each other, customers are
loyal but will switch if price is too high
I Carlsberg’s demand curve: qC = 50 + PK − 2PC
I Kingfisher’s demand curve: qK = 50 − PK + 2PC
I Both firms’ marginal cost of production is Rs. 2 per unit
(MCC = MCK )
I Compete in price, not capacity

I What will happen in this market?

I What is each firm’s production?
I What is price at which each is sold?
I What are the profits earned by each firm?
Bertrand Competition with Product Differentiation
Analysis of the beer industry

Profits are (profit margin) x (quantity)

Analysis for Carlsberg

Profit function is
ProfitC = (PC − MCC ) ∗ qC = (PC − 2) ∗ (50 + PK − 2PC )
Differentiate w.r.t. PC and set equal to zero
⇒ 50 + PK − 4PC + 4 = 0
⇒ PC = 54+P4
K

Analysis for Kingfisher

Profit function is
ProfitK = (PK − MCK ) ∗ qK = (PK − 2) ∗ (50 − PK + 2PC )
Differentiate w.r.t. PK and set equal to zero
⇒ 50 − 2PK + 2PC + 2 = 0
⇒ PC = PK − 26
Bertrand Competition with Product Differentiation
Reaction functions

Note: Not to scale.

Bertrand Competition with Product Differentiation
Solution

Solve two equations in two variables to get prices for each firm
PC∗ = 80
3 and PK∗ = 158
3

Put into demand functions to get quantities for each firm

⇒ qC∗ = 148
3 and qK∗ = 152
3

Calculate profits for each firm

⇒ Carlberg’s profits (PC∗ − MCC ) ∗ qC∗ ≈ 1217
and Kingfisher’s profits (PK∗ − MCK ) ∗ qK∗ ≈ 5269
Spot Market for Electricity in Italy

Source: Vishwanath Pingali

Markets with Dominant Firm

Definition
A dominant firm has significant market power and can set its price.
Fringe firms take as given the price set by the dominant firm.

Example
I Retail market with a big-box store and multiple mom-and-pop stores
I DSLR camera market with Canon and Nikon as dominant firms and
Leica and Pentax as fringe players
What to do when Wal-Mart comes to town

I Sequence of decisions
I Dominant firm sets price and quantity it will supply
I Fringe firm take price as given and decide their supply at that
price
Dominant Firm
Dominant Firm
Dominant Firm
Dominant Firm
Dominant Firm
Dominant Firm Analysis

Example
I Market demand function
I P = 100 − Q

I Sum of marginal costs of fringe firms

I MCF = 10 + 4Q

I Marginal cost of dominant firm

I MCD = 18

Source: From Gordon Cleveland’s notes.

Dominant Firm Analysis

Example
I Residual demand curve
I Vertical intercept of residual demand curve:
100 − Q = 10 + 4Q
I P = 82, Q = 0

I Residual demand intersects industry demand where quantity

supplied by fringe is 0
I P = 10, Q = 90

I Solve for equation of line through two points

I P = 82 − 0.8Q
Dominant Firm Analysis

Example
I Residual demand curve
I PD = 82 − 0.8Q

⇒ MR curve associated with residual demand curve

I MRD = 82 − 1.6Q
Dominant Firm Analysis

Example
I Dominant firm produces where MRD = MCD
I 82 − 1.6QD = 18
I QD = 40
I PD = 82 − (0.8 ∗ 40) = 50

I Dominant firm sets market price

I PD = P ∗ = 50

I Fringe firms take market price as given (P ∗ = MRF ) and produce

where MRF = MCF
I P ∗ = 10 + 4QF
⇒ QF = 10
Cartels

I Subset of producers in an industry who explicitly agree to cooperate

in setting prices and output
I Conditions for success:
1. Potential for monopoly power (inelastic demand)
2. “High enough” market share of cartel or inelastic supply of
non-cartel members
3. Agreement among members about prices and outputs
4. Incentive compatible to punish
Session Recap

I Most markets are oligopoly markets where firms have to consider

actions of other firms

I In Cournot competition, firms compete while making capacity

decisions simultaneously

I Stackelberg: Firms compete sequentially in capacity

I Bertrand: Firms compete in price with the same products

I Bertrand with product differentiation: Firms with similar (but not

same!) products compete in price

I Dominant firm: Dominant firm sets price, followed by fringe firms

Practice Problem

Two firms, the Alliance Company and the Bangor Corporation,

produce vision systems. The demand curve for vision systems is
P = 200000 − 6(qA + qB ) where P is the price (in dollars) of a
vision system, qA is the number of vision systems produced and sold
per month by Alliance, and qB is the number of vision systems
produced and sold per month by Bangor. Alliance’s total cost (in
dollars) is TCA = 8000qA and Bangor’s total cost (in dollars) is
TCB = 12000qB .
a. If managers at these two firms set their own output levels to
maximize profit, assuming that managers at the other firm
hold constant their output, what is the equilibrium price?
b. What is the output of each firm?
c. How much profit does each firm earn?
Note: Adapted from Allen et al.