Chapter 13

MONOPOLISTIC COMPETITION AND OLIGOPOLY

QUESTIONS AND ANSWERS

Q13.1 Describe the monopolistically competitive market structure and give some examples.

Q13.1 ANSWER

Monopolistic competition is a market structure quite similar to perfect competition in

that vigorous price competition among a large number of firms and individuals is
present. The major difference between these two market structures is that at least some
degree of product differentiation is present in monopolistically competitive markets.
As a result, firms have at least some discretion in setting prices. However, the
presence of many close substitutes limits the price-setting ability of individual firms,
and drives profits down to a normal rate of return in the long-run. As in the case of
perfect competition, above-normal profits are only possible in the short-run before
rivals are able to take effective counter measures.
Examples of monopolistically competitive market structures include a broad
range of industries producing clothing, consumer financial services, professional
services, restaurants, and so on.

Q13.2 Describe the oligopoly market structure and give some examples.

Q13.2 ANSWER

Oligopoly is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output. As in the case of monopoly, high to very high barriers
to entry are typical. Under oligopoly, the price/output decisions of firms are
interrelated in the sense that direct reactions from leading rivals can be expected. As a
result, the decision making of individual firms is based, in part, on the likely response
of competitors. This "competition among the few” involves a wide variety of price and
nonprice methods of interfirm rivalry, as determined by the institutional characteristics
of a particular market setting. Although fewness in the number of competitors gives
rise to a potential for excess profits, above-normal rates of return are far from
guaranteed. Competition among the few can sometimes be vigorous.
Examples of the oligopoly market structure include such industries as: bottled
and canned soft drinks, brokerage services, investment banking, long distance
telephone service, pharmaceuticals, ready-to-eat cereals, tobacco, and so on.
152 Chapter 13

Q13.3 Explain the process by which economic profits are eliminated in a monopolistically
competitive market as compared to a perfectly competitive market.

Q13.3 ANSWER

In a monopolistically competitive industry, excess profits are eliminated in the long-

run through imperfect emulation of successful product design, production systems, and
marketing efforts by both established and new competitors. Excess profits are
eliminated in a perfectly competitive industry through expansion by established firms
and entry of new firms, both of whom offer identical products that are perfect
substitutes.

Q13.4 Would you expect the demand curve for a firm in a monopolistically competitive
industry to be more or less elastic in the long run after competitor entry has eliminated
economic profits?

Q13.4 ANSWER

In most instances, demand will be more elastic in monopolistically competitive

industries after excess profits have been eliminated. The effect of increased
competition will typically be to make firm demand curves more elastic given the
greater availability of close substitutes. However, it is conceivable that increased
competition would simply involve a parallel leftward shift in the firm demand curve.
As discussed in the chapter, monopolistically competitive equilibrium will typically
involve a price-output combination between the high price-low output equilibrium
reached following a parallel leftward shift in demand, and the low price-high output
(perfectly competitive) equilibrium reached when the firm demand curve becomes
perfectly elastic.

Q13.5 “One might expect firms in a monopolistically competitive market to experience

greater swings in the price of their products over the business cycle than those in an
oligopoly market. However, fluctuations in profits do not necessarily follow the same
pattern.” Discuss this statement.

Q13.5 ANSWER

Oligopoly prices are expected to be more stable than those in a monopolistically

competitive industry. To see this, simply recall the discussion of the kinked oligopoly
demand curve and the fact that marginal cost changes within limits will not affect
prices, whereas similar cost changes would affect prices in a monopolistically
competitive industry. But would the more stable price pattern for firms in
monopolistically competitive industries produce a correspondingly more stable pattern
for profits? This is not entirely clear. This depends on a great many factors, including
the speed of entry and exit in response to profit changes, the level of fixed versus
Monopolistic Competition and Oligopoly 153

variable costs, and so on. For example, if entry conditions in the monopolistically
competitive industry allowed instantaneous entry, profits for individual firms might
closely reflect required rates of return and be quite stable. In general, the quicker
(slower) the return to equilibrium, the less (more) variable will be firm profits in
monopolistically competitive industries. In oligopoly markets, price tends to fluctuate
less than costs, and profits can be quite variable (e.g., ready-to-eat cereal and tobacco
industries).

Q13.6 What is the essential difference between the Cournot and Stackelberg models?

Q13.6 ANSWER

In the Cournot model, oligopoly firms make output decisions simultaneously. In the
Stackelberg model, oligopoly firms make output decisions sequentially rather than
simultaneously. In the Stackelberg model, a dominant firm is the first to set output,
and the remaining competitors follow that lead and make their own output decisions
given the output decision of the dominant first mover.

Q13.7 Which oligopoly model(s) result in long-run oligopoly market equilibrium that is
identical to a competitive market price/output solution?

Q13.7 ANSWER

In markets where competitors produce identical products, the Bertrand model and
contestable markets theory result in a long-run oligopoly market equilibrium
price/output solution that is identical to that achieved in a competitive market.
According to Bertrand, when products and production costs are identical all customers
will purchase from the firm selling at the lowest possible price. For example, consider
a duopoly where each firm has the same marginal costs of production. By slightly
undercutting the price charged by a rival, the competing firm would capture the entire
market. In response, the competing firm can be expected to slightly undercut the rival
price, thus recapturing the entire market. Such a price war would only end when the
price charged by each competitor converged on their identical marginal cost of
production, PA = PB = MC, and economic profits of zero would result. While critics
regard as implausible Bertrand’s prediction of a competitive-market equilibrium in
oligopoly markets that offer homogenous products, contestable markets theory
provides some additional useful perspective. Oligopoly firms will sometimes behave
much like perfectly competitive firms if potential entrants pose a credible threat and
entry costs are largely fungible rather than sunk.

Q13.8 Why is the four-firm concentration ratio only an imperfect measure of market power?

Q13.8 ANSWER
154 Chapter 13

The four firm concentration ratio measures the share of domestic output produced by
the top four firms in an industry. As such, it is only an imperfect measure of monopoly
power. First, concentration ratios ignore the magnitude of foreign competition. Such
competition limits the market power of industry leaders in automobile manufacturing,
electronics, television equipment and many other industries. And second,
concentration ratios compiled using national data fail to recognize regional market
power due to the local character of markets such as those for the newspapers, dairy
products, waste disposal, and so on. Thus, although foreign competition can
sometimes cause concentration ratios to overstate true market power by ignoring the
regional characteristics of many markets, concentration ratios can also understate
monopoly power in some instances.

Q13.9 The statement “You get what you pay for” reflects the common perception that high
prices indicate high product quality and low prices indicate low quality. Irrespective
of market structure considerations, is this statement always correct?

Q13.9 ANSWER

No, not necessarily. In both perfectly competitive and monopolistically competitive

markets P = AC in long run equilibrium. Given efficient methods of production, it is
reasonable to infer a close relation between prices and the costs of production, and
hence product quality, in such markets. However, in both monopoly and oligopoly
markets P > AC in long-run equilibrium. Therefore, there may only be a weak relation
between prices and the costs of production (product quality) in these markets. Thus,
the statement “You get what you pay for” may be quite descriptive of vigorously
competitive markets, but is less true in instances of imperfectly competitive markets.

Q13.10 “Economic profits result whenever only a few large competitors are active in a given
market.” Discuss this statement.

Q13.10 ANSWER

This statement is not true, and reflects a simplistic view of the link between the number
of competitors and the vigor of competition. Holding buyer power constant,
competition can sometimes be fierce in markets that involve only a handful of
competitors. Similarly, markets involving several “competitors” may have little or no
effective competition. For example, despite the fact that there are relatively few
providers of general aviation equipment, competition for new plane orders is often
fierce and suppliers seldom earn above-normal profits. On the other hand, textile and
agricultural markets involve thousands of competitors that are sometimes sheltered
from import competition by trade barriers and government price support programs. To
accurately assess the vigor of competition in any given market, one must carefully
analyze market structure (including the number and size distribution of competitors),
competitor behavior and industry performance.
Monopolistic Competition and Oligopoly 155

SELF-TEST PROBLEMS AND SOLUTIONS

ST13.1 Price Leadership. Over the last century, The Boeing Co. has become the largest
aerospace company in the world. Boeing’s principal global competitor is Airbus, a
company that has its roots in a European consortium of French, German and later,
Spanish and U.K companies. Though dominated by Boeing and Airbus, smaller firms
have recently entered the commercial aircraft industry. Notable among these is
Embraer, a Brazilian aircraft manufacturer. Embraer makes smaller commercial
aircraft that offer excellent reliability and cost effectiveness.
To illustrate the price leadership concept, assume that total and marginal cost
functions for Airbus (A) and Embraer (E) aircraft are as follows:

TCA = $10,000,000 + $35,000,000QA + $250,000QA2

MCA = $35,000,000 + $500,000QA

TCE = $200,000,000 + $20,000,000QE + $500,000QE2

MCE = $20,000,000 + $1,000,000QE

Boeing’s total and marginal cost relations are as follows:

TCB = $4,000,000,000 + $5,000,000QB + $62,500QB2

MCB = ∂ TCB/ ∂ QB = $5,000,000 + $125,000QB

The industry demand curve for this type of jet aircraft is

Q = 910 - 0.000017P

For simplicity, assume that Airbus and Embraer aircraft are perfect substitutes for
Boeing aircraft, and that each total cost function includes a risk-adjusted normal rate
of return on investment.

A. Determine the supply curves for Airbus and Embraer aircraft, assuming that the
firms operate as price takers.

B. What is the demand curve faced by Boeing?

C. Calculate Boeing’s profit-maximizing price and output levels. (Hint: Boeing’s

total and marginal revenue relations are TRB = $50,000,000QB - $50,000QB2,
and MRB =ΔTRB/ΔQB = $50,000,000 - $100,000QB.)

D. Calculate profit-maximizing output levels for the Airbus and Embraer aircraft.
156 Chapter 13

E. Is the market for aircraft from these three firms in short-run and in long-run
equilibrium?

ST13.1 SOLUTION

A. Because price followers take prices as given, they operate where individual marginal
cost equals price. Therefore, the supply curves for Airbus and Embraer aircraft are:

Airbus

PA = MCA = $35,000,000 + $500,000QA

500,000QA = -35,000,000 + PA

QA = -70 + 0.000002PA

Embraer

PE = MCE = $20,000,000 + $1,000,000QE

1,000,000QE = -20,000,000 + PE

QE = -20 + 0.000001PE

B. As the industry price leader, Boeing’s demand equals industry demand minus
following firm supply. Remember that P = PB = PM = PE because Boeing is a price
leader for the industry:

QB = Q - QA - QE

= 910 - 0.000017P + 70 - $0.000002P

+ 20 - $0.000001P

= 1,000 - 0.00002PB

PB = $50,000,000 - $50,000QB

C. To find Boeing’s profit maximizing price and output level, set MRB = MCB and solve
for Q:

MRB = MCB
Monopolistic Competition and Oligopoly 157

$50,000,000 - $100,000QB = $5,000,000 + $125,000QB

45,000,000 = 225,000QB

QB = 200 units

PB = $50,000,000 - $50,000(200)

= $40,000,000

D. Because Boeing is a price leader for the industry,

P = PB = PA = PE = $40,000,000

Optimal supply for Airbus and Embraer aircraft are:

QA = -70 + 0.000002PA

= -70 + 0.000002(40,000,000)

= 10

QE = -20 + 0.000001PE

= -20 + 0.000001(40,000,000)

= 20

E. Yes. The industry is in short-run equilibrium if the total quantity demanded is equal to
total supply. The total industry demand at a price of $40 million is:

QD = 910 - 0.000017P

= 910 - 0.000017(40,000,000)

= 230 units

The total industry supply is:

QS = QB + QA + QE

= 200 + 10 + 20

= 230 units
158 Chapter 13

Thus, the industry is in short-run equilibrium. The industry is also in long-run

equilibrium provided that each manufacturer is making at least a risk-adjusted normal
rate of return on investment. To check profit levels for each manufacturer, note that:

πA = TRA - TCA

= $40,000,000(10) -$10,000,000 -$35,000,000(10)

- $250,000(102)

= $15,000,000

πE = TRE - TCE

= $40,000,000(20) -$200,000,000 -$20,000,000(20)

- $500,000(202)

= $0

πB = TRB - TCB

= $40,000,000(200) -$4,000,000,000 - $5,000,000(200)

- $62,500(2002)

= $500,000,000

Boeing and Airbus are both earning economic profits, whereas Embraer, the
marginal entrant, is earning just a risk-adjusted normal rate of return. As such, the
industry is in long-rum equilibrium and there is no incentive to change.

STP13.2 Monopolistically Competitive Equilibrium. Soft Lens, Inc., has enjoyed rapid
growth in sales and high operating profits on its innovative extended-wear soft contact
lenses. However, the company faces potentially fierce competition from a host of new
competitors as some important basic patents expire during the coming year. Unless
the company is able to thwart such competition, severe downward pressure on prices
and profit margins is anticipated.

A. Use Soft Lens’s current price, output, and total cost data to complete the table:
Monopolistic Competition and Oligopoly 159

Monthly Total Marginal Total Marginal Average Total

Price Output Revenue Revenue Cost Cost Cost Profit

($) (million) ($million) ($million) ($million) ($million) ($million) ($million)

$20 0 $0
19 1 12
18 2 27
17 3 42
16 4 58
15 5 75
14 6 84
13 7 92
12 8 96
11 9 99
10 10 105

(Note: Total costs include a risk-adjusted normal rate of return.)

B. If cost conditions remain constant, what is the monopolistically competitive

high-price/low-output long-run equilibrium in this industry? What are industry
profits?

C. Under these same cost conditions, what is the monopolistically competitive low-
price/high-output equilibrium in this industry? What are industry profits?

D. Now assume that Soft Lens is able to enter into restrictive licensing agreements
with potential competitors and create an effective cartel in the industry. If
demand and cost conditions remain constant, what is the cartel price/output and
profit equilibrium?

STP13.2 SOLUTION

A.

Monthly Total Marginal Total Marginal Average Total

Price Output Revenue Revenue Cost Cost Cost Profit

($) (million) ($million) ($million) ($million) ($million) ($million) ($million)

$20 0 $0 --- $0 --- --- $0
19 1 19 $19 12 $12 $12.00 7
18 2 36 17 27 15 13.50 9
17 3 51 15 42 15 14.00 9
160 Chapter 13

Monthly Total Marginal Total Marginal Average Total

Price Output Revenue Revenue Cost Cost Cost Profit

($) (million) ($million) ($million) ($million) ($million) ($million) ($million)

16 4 64 13 58 16 14.50 6
15 5 75 11 75 17 15.00 0
14 6 84 9 84 9 14.00 0
13 7 91 7 92 8 13.14 -1
12 8 96 5 96 4 12.00 0
11 9 99 3 99 3 11.00 0
10 10 100 1 105 6 10.50 -5

B. The monopolistically competitive high-price/low-output equilibrium is P = AC = $14,

Q = 6(000,000), and π = TR - TC = $0. Only a risk-adjusted normal rate of return is
being earned in the industry, and excess profits equal zero. Because π = $0 and MR =
MC = $9, there is no incentive for either expansion or contraction. Such an
equilibrium is typical of monopolistically competitive industries where each individual
firm retains some pricing discretion in long-run equilibrium.

C. The monopolistically competitive low-price/high-output equilibrium is P = AC = $11,

Q = 9(000,000), and π = TR - TC = $0. Again, only a risk-adjusted normal rate of
return is being earned in the industry, and excess profits equal zero. Because π = $0
and MR = MC = $3, there is no incentive for either expansion or contraction. This
price/output combination is identical to the perfectly competitive equilibrium. (Note
that average cost is rising and profits are falling for Q > 9.)

D. A monopoly price/output equilibrium results if Soft Lens is able to enter into restrictive
licensing agreements with potential competitors and create an effective cartel in the
industry. If demand and cost conditions remain constant, the cartel price/output and
profit equilibrium is at P = $17, Q = 3(000,000), and π = $9(000,000). There is no
incentive for the cartel to expand or contract production at this level of output because
MR = MC = $15.

PROBLEMS AND SOLUTIONS

P13.1 Market Structure Concepts. Indicate whether each of the following statements is true
or false and explain why.

A. Equilibrium in monopolistically competitive markets requires that firms be

operating at the minimum point on the long-run average cost curve.

B. A high ratio of distribution cost to total cost tends to increase competition by

widening the geographic area over which any individual producer can compete.
Monopolistic Competition and Oligopoly 161

C. The price elasticity of demand tends to fall as new competitors introduce

substitute products.

D. An efficiently functioning cartel achieves a monopoly price/output combination.

E. An increase in product differentiation tends to increase the slope of firm demand

curves.

P13.1 SOLUTION

A. False. Stable equilibrium in perfectly competitive markets requires that firms must
operate at the minimum point on the long-run average cost curve. In monopolistically
competitive markets, however, equilibrium is achieved at a point of tangency between
firm demand and average cost curves. This tangency typically occurs at an output
level below the point of minimum long-run average costs.

B. False. A low ratio of distribution cost to total cost tends to increase competition by
widening the geographic area over which any individual producer can compete.

C. False. The price elasticity of demand tends to rise as new competitors introduce
substitute products.

D. True. A perfectly functioning cartel achieves the monopoly price-output combination.

E. True. An increase in product differentiation tends to increase the slope of individual

firm demand curves.

P13.2 Monopolistically Competitive Demand. Would the following factors increase or

decrease the ability of domestic auto manufacturers to raise prices and profit
margins? Why?

A. Decreased import quotas

B. Elimination of uniform emission standards

C. Increased automobile price advertising

D. Increased import tariffs (taxes)

E. A rising value of the dollar, which has the effect of lowering import car prices

P13.2 SOLUTION
162 Chapter 13

A. Increase. As import quotas are decreased, fewer substitutes for domestic automobiles
become available. This will decrease competition in the industry, and ease pressure on
profit margins.

B. Increase. An elimination of uniform emission standards reduces product homogeneity.

As product differentiation rises, some increase in the pricing discretion of firms will
result.

C. Decrease. An increase in automobile price advertising increases price competition in

the industry and thereby decreases the ability of firms to raise prices and profit
margins.

D. Increase. An increase in import tariffs (taxes) increases the price of import cars, thus
making imports less attractive to car buyers. This will reduce the price pressure on
domestic manufacturers, and make it easier for them to increase profit margins.

E. Decrease. A rising value of the dollar that has the effect of lowering import car prices
puts downward pressure on the profit margins of domestic manufacturers.

P13.3 Competitive Markets v. Cartels. Suppose the City of Columbus, Ohio, is considering
two proposals to privatize municipal garbage collection. First, a handful of leading
waste disposal firms have offered to purchase the city's plant and equipment at an
attractive price in return for exclusive franchises on residential service in various
parts of the city. A second proposal would allow several individual workers and small
companies to enter the business without any exclusive franchise agreements or
competitive restrictions. Under this plan, individual companies would bid for the right
to provide service in a given residential area. The City would then allocate business
to the lowest bidder.
The City has conducted a survey of Columbus residents to estimate the amount
that they would be willing to pay for various frequencies of service. The City has also
estimated the total cost of service per resident. Service costs are expected to be the
same whether or not an exclusive franchise is granted.

A. Complete the following table.

Trash Pickups Price per Total Marginal Total Marginal

per Month Pickup Revenue Revenue Cost Cost
0 $5.00 $0.00
1 4.80 3.75
2 4.60 7.45
3 4.40 11.10
Monopolistic Competition and Oligopoly 163

Trash Pickups Price per Total Marginal Total Marginal

per Month Pickup Revenue Revenue Cost Cost
4 4.20 14.70
5 4.00 18.00
6 3.80 20.90
7 3.60 23.80
8 3.40 27.20
9 3.20 30.70
10 3.00 35.00

B. Determine price and service level if competitive bidding results in a

perfectly competitive price/output combination.

C. Determine price and the level of service if local regulation results in a

cartel.

P13.3 SOLUTION

A.

Trash Pickups Price per Total Marginal Total Marginal

per Month Pickup Revenue Revenue Cost Cost
0 $5.00 $0.00 -- $0.00 --
1 4.80 4.80 $4.80 3.75 $3.75
2 4.60 9.20 4.40 7.45 3.70
3 4.40 13.20 4.00 11.10 3.65
4 4.20 16.80 3.60 14.70 3.60
5 4.00 20.00 3.20 18.00 3.30
6 3.80 22.80 2.80 20.90 2.90
7 3.60 25.20 2.40 23.80 2.90
8 3.40 27.20 2.00 27.20 3.40
9 3.20 28.80 1.60 30.70 3.50
10 3.00 30.00 1.20 35.00 4.30

B. In a perfectly competitive industry, P = MR, so the optimal activity level occurs where
P = MC. Here, P = MC = $3.40 at Q = 8 pickups per month.
164 Chapter 13

C. A monopoly cartel maximizes profits by setting MR = MC. Here, MR = MC = $3.60

at Q = 4 pickups per month and P = $4.20 per pickup.

P13.4 Monopolistic Competition. Gray Computer, Inc., located in Colorado Springs,

Colorado, is a privately held producer of high-speed electronic computers with
immense storage capacity and computing capability. Although Gray’s market is
restricted to industrial users and a few large government agencies (e.g., Department of
Health, NASA, National Weather Service, etc.), the company has profitably exploited
its market niche. Suppose a potential entrant into the market for supercomputers has
asked you to evaluate the short- and long-run potential of this market. The following
market demand and cost information has been developed:

P = $54 - $1.5Q,

MR = ΔTR/ΔQ = $54 - $3Q,

TC = $200 + $6Q + $0.5Q2,

MC = ΔTC/ΔQ = $6 + $1Q,

where P is price, Q is units measured by the number of supercomputers, MR is

marginal revenue, TC is total costs including a normal rate of return, MC is marginal
cost, and all figures are in millions of dollars.

A. Assume that these demand and cost data are descriptive of Gray’s historical
experience. Calculate output, price, and economic profits earned by Gray
Computer as a monopolist. What is the point price elasticity of demand at this
output level?

B. Calculate the range within which a long-run equilibrium price/output

combination would be found for individual firms if entry eliminated Gray’s
economic profits. (Note: Assume that the cost function is unchanged and that
the high-price/low-output solution results from a parallel shift in the demand
curve while the low-price/high-output solution results from a competitive
equilibrium.)

C. Assume that the point price elasticity of demand calculated in Part A is a good
estimate of the relevant arc price elasticity. What is the potential overall market
size for supercomputers?

D. If no other near-term entrants are anticipated, should your company enter the
market for supercomputers? Why or why not?
Monopolistic Competition and Oligopoly 165

P13.4 SOLUTION

A. Set MR = MC to determine the profit-maximizing activity level.

MR = MC

$54 - $3Q = $6 + $1Q

4Q = 48

Q = 12

and

P = $54 - $1.5Q

= $54 - $1.5(12)

= $36 million

π = -$2(122) + $48(12) - $200

= $88 million

From the demand curve note that:

Q = 36 - 0.67P,

which, at the profit-maximizing activity level, implies a point price elasticity of

εP = ΔQ/ΔP × P/Q

= -0.67 Η 36/12

= -2

(Note: Profits are declining for Q > 12.)

B. The high-price/low-output equilibrium point is identified by the point of tangency

between the firm’s demand and average cost curves which occur after a parallel
leftward shift in demand due to competitor entry. Therefore, in equilibrium the new
firm demand and average cost curves have the same slope.
To determine the slope of the average cost curve note that:
166 Chapter 13

$200 + $6 Q + $0.5 Q2
AC = TC/Q =
Q

= $200Q-1 + $6 + $0.5Q

Slope of average
cost curve = ΔAC/ΔQ = -200Q-2 + 0.5

Slope of new
demand curve = -1.5 (Same as for original demand curve)

And in equilibrium,

Slope of average Slope of new

cost curve = demand curve

-200Q-2 + 0.5 = -1.5

Q-2 = 2/200

Q2 = 100

Q = 10

and

P = AC = $200(10-1) + $6 + $0.5(10)

= $31 million

π = P × Q - TC

= $31(10) - $200 - $6(10) - $0.5(102)

= $0

The low-price/high-output equilibrium point occurs where P = AC and average

costs are minimized (this is also the perfectly competitive equilibrium). Set MC = AC
to determine the point of minimum average costs, and solve for Q:

MC = AC

$6 + $1Q = $200Q-1 + $6 + $0.5Q

Monopolistic Competition and Oligopoly 167

200Q-1 = 0.5Q

200Q-2 = 0.5

Q2 = 200/0.5

= 400

Q = 400

= 20

and

P = AC = $200(20-1) + $6 + $0.5(20)

= $26 million

π = P Η Q - TC

= $26(20) - $200 - $6(20) - $0.5(202)

= $0

C. If the high-price/low-output equilibrium is achieved in the long run, total industry

output rises to 16.2 supercomputers because:

Q2 - Q1 P 2 + P1
EP = ×
P 2 - P1 Q2 + Q1

Q2 - 12 31 + 36
-2 = ×
31 - 36 Q2 + 12

67( Q2 - 12)
-2 =
- 5(Q2 + 12)

10(Q2 + 12) = 67(Q2 - 12)

10Q2 + 120 = 67Q2 - 804

57Q2 = 924
168 Chapter 13

Q2 = 16.2

Conversely, if the low-price/high-output equilibrium is achieved, total industry output

rises to 23.4 supercomputers because:

Q 2 - Q1 P 2 + P1
EP = ×
P 2 - P1 Q2 + Q1

Q2 - 12 26 + 36
-2 = ×
26 - 36 Q2 + 12

62( Q2 - 12)
-2 =
- 10( Q2 + 12)

20(Q2 + 12) = 62(Q2 - 12)

20Q2 + 240 = 62Q2 - 744

42Q2 = 984

Q2 = 23.4

D. No. Entry into this industry is unwise. Gray currently sells 12 supercomputers per
year, a substantial share of the projected long-run potential of between 16.2 and 23.4
for total industry output. Moreover, the industry does not have the potential to support
more than one firm of Q = 20 size class, the minimum optimal firm size. Therefore, by
virtue of its role as an industry leader of dominant proportions, Gray would have the
capability to continuously undercut new rivals and make profitable entry very difficult,
if not impossible. (Note: Fractional output can be completed during subsequent
periods).

P13.5 Cartel Equilibrium. Assume the Hand Tool Manufacturing Industry Trade
Association recently published the following estimates of demand and supply relations
for hammers:

QD = 60,000 - 10,000P (Demand),

QS = 20,000P (Supply).

A. Calculate the perfectly competitive industry equilibrium price/output

combination.
Monopolistic Competition and Oligopoly 169

B. Now assume that the industry output is organized into a cartel. Calculate the
industry price/output combination that will maximize profits for cartel members.
(Hint: As a cartel, industry MR = $6 - $0.0002Q.)

C. Compare your answers to parts A and B. Calculate the price/output effects of

the cartel.

P13.5 SOLUTION

A. The industry equilibrium price is determined by setting:

QD = QS

60,000 - 10,000P = 20,000P

P = $2

At P = $2, the equilibrium output is 40,000 because:

QD ?= QS

60,000 - 10,000(2) ?= 20,000(2)

40,000 = 40,000

B. The profit-maximizing activity level is found where MR = MC. Here it is important to

recognize that the industry supply curve represents the horizontal sum of the marginal
cost curves for individual producers. Therefore, when the industry is organized into a
cartel and acts like a monopolist, the industry supply curve represents the relevant
marginal cost curve:

QS = 20,000P (Supply)

MC = P = $0.00005Q

From the demand curve:

QD = 60,000 - 10,000P (Demand)

P = $6 - $0.0001Q

TR = P×Q
170 Chapter 13

= ($6 - $0.0001Q)Q

= $6Q - $0.0001Q2

MR = ΔTR/ΔQ = $6 - $0.0002Q

And the profit-maximizing activity level is found by setting MR = MC and solving for
Q:

MR = MC

$6 - $0.0002Q = $0.00005Q

0.00025Q = 6

Q = 24,000

P = $6 - $0.0001(24,000)

= $3.60

C. With a cartel, the level of industry output falls from 40,000 to 24,000 units and price
rises from $2 to $3.60, when compared with the perfectly competitive industry.
Generally speaking, monopolists offer consumers too little output at too high a price.

P13.6 Cournot Equilibrium. VisiCalc, the first computer spreadsheet program, was
released to the public in 1979. A year later, introduction of the DIF format made
spreadsheets much more popular because they could now be imported into word
processing and other software programs. By 1983, Mitch Kapor used his previous
programming experience with VisiCalc to found Lotus Corp. and introduce the wildly
popular Lotus 1-2-3 spreadsheet program. Despite enormous initial success, Lotus 1-
2-3 stumbled when Microsoft Corp. introduced Excel with a much more user-friendly
graphical interface in 1987. Today, Excel dominates the market for spreadsheet
applications software.
To illustrate the competitive process in markets dominated by few firms, assume
that a two-firm duopoly dominates the market for spreadsheet application software,
and that the firms face a linear market demand curve

P = $1,250 - Q

where P is price and Q is total output in the market (in thousands) . Thus Q = QA +
QB. For simplicity, also assume that both firms produce an identical product, have no
Monopolistic Competition and Oligopoly 171

fixed costs and marginal cost MCA = MCB = $50. In this circumstance, total revenue
for Firm A is

TRA = $1,250QA - QA2 - QAQB

Marginal revenue for Firm A is

MRA = ΔTRA/ΔQA = $1,250 - $2QA - QB

Similar total revenue and marginal revenue curves hold for Firm B.

A. Derive the output reaction curves for Firms A and B.

B. Calculate the Courtnot market equilibrium price-output solutions.

P13.6 SOLUTION

A. Because MCA = 0, Firm A’s profit-maximizing output level is found by setting MRA =
MCA = 0:

MRA = MCA

$1,250 - $2QA - QB = 50

$2QA = $1,200 - QB

QA = 600 - 0.5QB

Notice that the profit-maximizing level of output for Firm A depends upon the level of
output produced by itself and Firm B. Similarly, the profit-maximizing level of output
for Firm B depends upon the level of output produced by itself and Firm A. These
relationships are each competitor’s output-reaction curve

Firm A output-reaction curve: QA = 600 - 0.5QB

Firm B output-reaction curve: QB = 600 - 0.5QA

B. The Cournot market equilibrium level of output is found by simultaneously solving the
output-reaction curves for both competitors. To find the amount of output produced by
Firm A, simply insert the amount of output produced by competitor Firm B into Firm
A’s output-reaction curve and solve for QA. To find the amount of output produced by
Firm B, simply insert the amount of output produced by competitor Firm A into Firm
172 Chapter 13

B’s output-reaction curve and solve for QB. For example, from the Firm A output-
reaction curve

QA = 600 - 0.5QB

QA = 600 - 0.5(600 - 0.5QA)

QA = 600 - 300 + 0.25QA

0.75QA = 300

QA = 400 (000) units

Similarly, from the Firm B output-reaction curve, the profit-maximizing level of output
for Firm B is QB = 400. With just two competitors, the market equilibrium level of
output is

Cournot equilibrium output = QA + QB

= 400 + 400

= 800 (000) units

The Cournot market equilibrium price is

Cournot equilibrium price = $1,250 - Q

= $1,250 - $1(800)

= $450

P13.7 Stackelberg Model. Imagine that a two-firm duopoly dominates the market for
spreadsheet application software for personal computers. Also assume that the firms
face a linear market demand curve

P = $1,250 - Q

where P is price and Q is total output in the market (in thousands) . Thus Q = QA +
QB. For simplicity, also assume that both firms produce an identical product, have no
fixed costs and marginal cost MCA = MCB = $50. In this circumstance, total revenue
for Firm A is

TRA = $1,250QA - QA2 - QAQB

Monopolistic Competition and Oligopoly 173

Marginal revenue for Firm A is

MRA = ΔTRA/ΔQA = $1,250 - $2QA - QB

Similar total revenue and marginal revenue curves hold for Firm B.

A. Calculate the Stackelberg market equilibrium price-output solutions.

B. How do the Stackelberg equilibrium price-output solutions differ from those

suggested by the Cournot model? Why?

P13.7 SOLUTION

A. To illustrate Stackelberg first-mover advantages, reconsider the Cournot model but

now assume that Firm A, as a leading firm, correctly anticipates the output reaction of
Firm B, the following firm. With prior knowledge of Firm B’s output-reaction curve,
QB = 600 - 0.5QA, Firm A’s total revenue curve becomes

TRA = $1,250QA - QA2 - QAQB

= $1,250QA - QA2 - QA(600 - 0.5QA)

= $650QA - 0.5QA2

With prior knowledge of Firm B’s output-reaction curve, marginal revenue for Firm A
is

MRA = ΔTRA/ΔQA = $650 - $1QA

Because MCA = $50, Firm A’s profit-maximizing output level with prior knowledge of
Firm B’s output-reaction curve is found by setting MRA = MCA = $50:

MRA = MCA

$650 - $1QA = $50

QA = 600

After Firm A has determined its level of output, the amount produced by Firm B is
calculated from Firm B’s output-reaction curve

QB = 600 - 0.5QA

= 600 - 0.5(600)
174 Chapter 13

= 300

With just two competitors, the Stackelberg market equilibrium level of output is

Stackelberg equilibrium output = QA + QB

= 600 + 300

= 900 (000) units

The Stackelberg market equilibrium price is

Stackelberg equilibrium price = $1,250 - Q

= $1,250 - $1(900)

= $350

B. Notice that market output is greater in Stackelberg equilibrium than in Cournot

equilibrium because the first mover, Firm A, produces more output while the follower,
Firm B, produces less output. Stackelberg equilibrium also results in a lower market
price than that observed in Cournot equilibrium. In this example, Firm A enjoys a
significant first-mover advantage. Firm A will produce twice as much output and earn
twice as much profit as Firm B so long as Firm B accepts the output decisions of Firm
A as given and does not initiate a price war. If Firm A and Firm B cannot agree on
which firm is the leader and which firm is the follower, a price war can break out with
the potential to severely undermine the profitability of both leading and following
firms. If neither duopoly firm is willing to allow its competitor to exercise a market
leadership position, vigorous price competition and a competitive market price/output
solution can result. Obviously, participants in oligopoly markets have strong
incentives to resolve the uncertainty surrounding the likely competitor response to
leading-firm output decisions.

P13.8 Bertrand Equilibrium. Coke and Pepsi dominate the U. S soft-drink market.
Together, they account for about 75% of industry sales. Suppose the quantity of Coke
demanded depends upon the price of Coke (PC) and the price of Pepsi (PP)
QC = 15 - 2.5PC + 1.25PP

where output (Q) is measured in millions of 24-packs per month, and price is the
wholesale price of a 24-pack. For simplicity, assume average costs are constant and
AC = MC = X dollars per unit. In that case, the total profit and change in profit with
respect to own price functions for Coke are
Monopolistic Competition and Oligopoly 175

πC = TRC - TCC = PCQC - XQC = (PC - X) QC

ΔπC/ΔPC = 15 - 5PC + 1.25PP + 2.5X

A. Set Δ πC/ΔPC = 0 to derive Coke’s optimal price-response curve. Interpret your

answer.

B. Calculate Coke’s optimal price-output combination if Pepsi charges $5 and

marginal costs are $2 per 24-pack.

P13.8 SOLUTION

A. To derive Coke’s optimal price-response curve, set

ΔπC/ΔPC = 0

15 - 5PC + 1.25PP +2.5X = 0

5PC = 15 + 1.25PP + 2.5X

PC = $3 + $0.25PP + $0.5X

Coke’s optimal price-response curve shows that Coke should increase its own price by
25¢ with each $1 increase in the price of Pepsi, and increase its own price by 50¢ with
every $1 increase in the marginal cost of production.

B. If Pepsi charges $5 and marginal costs are $2 per 24-pack, Coke’s optimal price-
response curve shows that Coke should charge $5.25 per 24-pack:

PC = $3 + $0.25PP + $0.5X

= $3 + $0.25($5) + $0.5($2)

= $5.25

P13.9 Kinked Demand Curves. Assume Safety Service Products (SSP) faces the following
segmented demand and marginal revenue curves for its new infant safety seat:

1. Over the range from 0 to 10,000 units of output,

P1 = $60 - Q,

MR1 = ΔTR1/ΔQ = $60 - $2Q.

176 Chapter 13

2. When output exceeds 10,000 units,

P2 = $80 - $3Q,

MR2 = ΔTR2/ΔQ = $80 - $6Q.

The company’s total and marginal cost functions are as follows:

TC = $100 + $20Q + $0.5Q2,

MC = ΔTC/ΔQ = $20 + $1Q,

where P is price (in dollars); Q is output (in thousands); MR is marginal revenue; TC

is total cost; and MC is marginal cost, all in thousands of dollars.

A. Graph the demand, marginal revenue, and marginal cost curves.

B. How would you describe the market structure of the industry in which SSP
operates? Explain why the demand curve takes the shape indicated previously.

C. Calculate price, output, and profits at the profit-maximizing activity level.

D. How much could marginal costs rise before the optimal price would increase?
How much could they fall before the optimal price would decrease?

P13.9 SOLUTION

A. Note that:

MR1 = ΔTR1/ΔQ = $60 - $2Q

MR2 = ΔTR2/ΔQ = $80 - $6Q

MC = ΔTC/ΔQ = $20 + Q
Monopolistic Competition and Oligopoly 177

S a fe ty S e rvic e P ro d uc ts (S S P )
D o lla rs ($ )
K ink e d D e m a nd C urve A na lys is
$90

$80

$70
P1 = $ 6 0 - $ 1 Q
$60
(1 0 , 5 0 )
$50
M R1 = $ 6 0 - $ 2 Q
$40 (1 0 , 4 0 )

$30

$20 (1 0 , 2 0 )
M C = $20 + $1Q P2 = $ 8 0 - $ 3 Q
$10
M R2 = $ 8 0 - $ 6 Q
$0
0 5 10 15 20
O u tp u t (0 0 0 )

B. The firm is in an oligopoly market. It faces a kinked demand curve, indicating that
competitors will react to price reductions by cutting their own prices and causing the
segment of the demand curve below the kink to be relatively inelastic. Price increases
are not followed, causing the portion of the demand curve above the kink to be
relatively elastic.

C. An examination of the graph indicates that the marginal cost curve passes through the
gap in the marginal revenue curve. Graphically, this indicates optimal P = $50 and Q =
10(000). Analytically,

MR1 = $60 - $2Q Q ≤ 10,000

MR2 = $80 - $6Q Q > 10,000

178 Chapter 13

MC = $20 + $Q

MR1 > MC over the range Q ≤ 10(000), and MR2 < MC for the range Q > 10(000).
Therefore, SSP will produce 10(000) units of output and market them at a price P1 =
$60 - Q = $60 - $(10) = $50. Alternatively, P2 = $80 - $3Q = $80 - $3(10) = $50.

At P = $50 and Q = 10:

π = TR - TC

= $50(10) - $100 - $20(10) - $0.5(102)

= $150(000) or $150,000

D. At Q = 10(000),

MR1 = $60 - $2Q MR2 = $80 - $6Q

= $60 - $2(10) = $80 - $6(10)

= $40 = $20

This implies that if marginal costs at Q = 10(000) exceed $40, the optimal price would
increase. Conversely, if marginal costs at Q = 10(000) fall below $20, the optimal
price would decrease. So long as marginal cost at Q = 10(000) is in the range of $20 to
$40, SSP will have no incentive to change in price.

P13.10 Market Structure Measurement. In 2005, Federated Department Stores, Inc.

proposed to acquire The May Department Stores Co., thereby combining the two
largest chains in the United States of so-called “traditional” or “conventional”
department stores. Conventional department stores typically anchor enclosed
shopping malls, feature products in the mid-range of price and quality, and sell a wide
range of products. The proposed transaction would create high levels of concentration
among conventional department stores in many metropolitan areas of the United
States, and the merged firm would become the only conventional department store at
certain of the 1,200 malls in the United States.

A. How is the cross-elasticity concept used to empirically define economic

markets?

B. Explain how the government’s finding that conventional department stores

compete against specialty stores led them to approve the proposed merger.
Monopolistic Competition and Oligopoly 179

P13.10 SOLUTION

A. An economic market consists of all individuals and firms willing and able to buy or
sell competing products during a given period. The key criterion in identifying
competing products is similarity in use. Precise determination of whether a specific
good is a distinct economic product involves an evaluation of cross-price elasticity for
broad classes of goods. When cross-price elasticity is large and positive, goods are
substitutes for each other and can be thought of as competing products in a single
market. Conversely, large negative cross-price elasticity indicates complementary
products. Complementary products produced by a single firm must be evaluated as a
single product line serving the same market. If complementary products are produced
by other companies, evaluating the potential of a given product line involves
incorporating exogenous influences beyond the firm's control. When cross-price
elasticity is near zero, goods are in separate economic markets and can be separately
analyzed as serving distinct consumer needs.

B. In examining the Federated proposal to acquire May Department Stores, the key
question is the extent to which conventional department stores represent a distinct
economic market. If traditional department stores compete against specialty stores and
discount department stores, then it becomes appropriate to consider the relative size of
these two competitors in a broader characterization of the market that includes all
relevant competitors. If the relevant product market included only conventional
department stores, then before the merger Federated had a market share greater than
90% in the New York–New Jersey metropolitan area. If the relevant product market
also included, for example, specialty stores, then Federated’s share in that geographic
area was much smaller. The evidence that Commission staff obtained indicated that
the relevant product market was broader than conventional department stores. In the
New York–New Jersey metropolitan area, Federated charged consumers the same
prices that it charged throughout much of the eastern region of the United States,
including where Federated faced larger numbers of traditional department store rivals.
May and other department store chains, like Federated, also set prices to consumers
that were uniform over very broad geographic areas and did not appear to vary local
prices based on the number or identity of conventional department stores in malls or
metropolitan areas.
This evidence provided support for the conclusion that the acquisition likely would not
create anticompetitive effects. Staff also found no evidence that competitive
constraints, e.g., rivalry from retailers other than department stores, in New York–
New Jersey were not representative of other markets in which Federated and May
competed. Further, evidence pertaining both to which firms the parties monitored for
pricing and to consumer purchasing behavior also supported the conclusion that the
relevant market was sufficiently broad that the merger was not likely to cause
anticompetitive effects.
180 Chapter 13

CASE STUDY FOR CHAPTER 13

Market Structure Analysis at Columbia Drugstores, Inc.

Demonstrating the tools and techniques of market structure analysis is made difficult by the fact
that firm competitive strategy is largely based upon proprietary data. Firms jealously guard
price, market share and profit information for individual markets. Nobody should expect Target,
for example, to disclose profit and loss statements for various regional markets or on a store-by-
store basis. Competitors like Wal-Mart would love to have such information available; it would
provide a ready guide for their own profitable market entry and store expansion decisions.
To see the process that might be undertaken to develop a better understanding of product
demand conditions, consider the hypothetical example of Columbia Drugstores, Inc., based in
Seattle, Washington. Assume Columbia operates a chain of 30 drugstores in the Pacific
Northwest. During recent years, the company has become increasingly concerned with the
long-run implications of competition from a new type of competitor, the so-called superstore.
To measure the effects of superstore competition on current profitability, Columbia asked
management consultant Peter Parker to conduct a statistical analysis of the company’s
profitability in its various markets. To net out size-related influences, profitability was measured
by Columbia’s gross profit margin, or earnings before interest and taxes divided by sales.
Columbia provided proprietary company profit, advertising, and sales data covering the last year
for all 30 outlets, along with public trade association and Census Bureau data concerning the
number and relative size distribution of competitors in each market, among other market
characteristics.
As a first step in the study, Parker decided to conduct a regression-based analysis of the
various factors thought to affect Columbia’s profitability. The first is the relative size of leading
competitors in the relevant market, measured at the Standard Metropolitan Statistical Area
(SMSA) level. Given the pricing, marketing, and average-cost advantages that accompany large
relative size, Columbia’s market share, MS, in each area is expected to have a positive effect on
profitability. The market concentration ratio, CR, measured as the combined market share of the
four largest competitors in any given market, is expected to have a negative effect on Columbia’s
profitability given the stiff competition from large, well-financed rivals. Of course, the expected
negative effect of high concentration on Columbia profitability contrasts with the positive
influence of high concentration on industry profits that is sometimes observed.
Both capital intensity, K/S, measured by the ratio of the book value of assets to sales, and
advertising intensity, A/S, measured by the advertising-to-sales ratio, are expected to exert
positive influences on profitability. Given that profitability is measured by Columbia’s gross
profit margin, the coefficient on capital intensity measured Columbia’s return on tangible
investment. Similarly, the coefficient on the advertising variable measures the profit effects of
advertising. Growth, GR, measured by the geometric mean rate of change in total disposable
income in each market, is expected to have a positive influence on Columbia’s profitability,
because some disequilibrium in industry demand and supply conditions is often observed in
rapidly growing areas. Columbia’s proprietary information is shown in Table 13.3
Finally, to gauge the profit implications of superstore competition, Parker used a
“dummy” (or binary) variable where S = 1 in each market in which Columbia faced superstore
Monopolistic Competition and Oligopoly 181

competition and S = 0 otherwise. The coefficient on this variable measures the average profit rate
effect of superstore competition. Given the vigorous nature of superstore price competition,
Parker expects the superstore coefficient to be both negative and statistically significant,
indicating a profit-limiting influence. The Columbia profit-margin data and related information
used in Parker’s statistical analysis are given in the preceding table. Regression model estimates
for the determinants of Columbia’s profitability are shown in Table 13.4.

A. Describe the overall explanatory power of this regression model, as well as the
relative importance of each continuous variable.

B. Based on the importance of the binary or dummy variable that indicates superstore
competition, do superstores pose a serious threat to Columbia’s profitability?

C. What factors might Columbia consider in developing an effective competitive strategy

to combat the superstore influence?

CASE STUDY SOLUTION

A. The coefficient of determination R2 = 77.7% means that 77.7% of the total variation in
Columbia’s profit-margins can be explained by the regression model. This is a
relatively high level of statistically significant explanation (F = 13.38) for a cross-
section study such as this, suggesting that the model provides useful insight concerning
the determinants of profitability. The standard error of the estimate (S.E.E. =
2.1931%) means that there is roughly a 95% chance that the actual profit margins for a
given store will lie within the range of the estimated or fitted value ± 2 × S.E.E., or ± 2
× 2.1931%.
The intercept coefficient of 6.155 has no economic meaning because it lies far
outside the relevant range of observed data. The 0.189 coefficient for the market-share
variable means that, on average, a 1% (unit) rise in Columbia’s market share leads to a
0.189% (unit) rise in Columbia’s profit margin. Similarly, as expected, Columbia’s
profit margin is positively related to capital intensity, advertising intensity, and the rate
of growth in the market area. Conversely, high concentration has the expected limiting
influence. Because of the effects of leading-firm rivalry, a 1% rise in industry
concentration will lead to a 0.156% decrease in Columbia’s profit margin. This means
that relatively large firms compete effectively with Columbia.

B. Yes, the regression model indicates that superstore competition in one of Columbia’s
market areas reduces Columbia’s profit margin on average by 2.102%. Given that
Columbia’s rate of return on sales routinely falls in the 10% to 15% range, the
profit-limiting effect of superstore competition is substantial. Looking more closely at
the data, it appears that Columbia faces superstore competition in only one of the seven
lucrative markets in which the company earns a 20% to 25% rate of return on sales.
Both observations suggest that current and potential superstore competition constitutes
182 Chapter 13

a considerable threat to the company and one that must be addressed in an effective
competitive strategy.

C. Development of an effective competitive strategy to combat the influence of

superstores involves the careful consideration of a wide range of factors related to
Columbia’s business. It might prove fruitful to begin this analysis by more carefully
considering market characteristics for Store No. 6, the one Columbia outlet able to earn
a substantial 20% profit margin despite superstore competition. For example, this
analysis might suggest that Columbia, like Store No. 6, should specialize in service
(e.g., prescription drug delivery) or in a slightly different mix of merchandise. On the
other hand, perhaps Columbia should follow the example set by Wal-Mart in its early
development and focus its plans for expansion on small to medium-size markets. In
the meantime, Columbia’s still-profitable stores in major metropolitan areas could help
fund future growth.
Although obviously only a first step, a regression-based study of market structure
such as that described here can provide a very useful beginning to the development of
an effective competitive strategy.