Chapter Two

Oligopoly

Oligopoly is a market structure in which a few large firms produce homogeneous or

differentiated products. Oligopoly model focuses on the examination of strategic interaction in
an industry with a few numbers of firms.

Assumptions
- Small number of firms where two or more large firms dominate the market.
- The firms produce either differentiated or homogeneous products.
- Each firm has a large make share.
- Firms make price and output decisions strategically taking into account the possible actions
of the other firms in the market i.e. firms are interdependent.
- The firms have an incentive to collude.
- There are natural or legal barriers to entry that could be due to :
- legal barriers like patents.
- control over technology or raw materials
- Strategic actions by the existing firms to deter the entry of new firms. For example, by
keeping excess capacity and they can threat to flood the market and reduce the price if
entry occurs
- The capital investment requirement may be large.
- Scale economies may make it unprofitable for more than a few firms to coexist in the
markets (the market is too small to many firms).

The firms in such market are highly interdependent. i.e., the decision of any one firm will have
considerable impact on others. Oligopoly model try to analyze such strategic interactions
between oligopoly firms.
Interdependence

- When a small number of firms compete in a market they are interdependent in the sense that
the profit earned by each firm depends on the firm’s own actions and on the actions of the
other firm.
- Before making a decision, each firm must consider how the other firms will react to its
decision and influence its profit.
- The importance of interdependence is that it leads to strategic behavior. Strategic behavior is
the behavior that occurs when what is best for A depends upon what B does, and what is best
for B depends upon what A does.
There are different types of oligopoly models, and thus there is no single general model. We try
to capture the most important features of strategic behaviors. To study these behaviors we start

1
with the simple case of duopoly models. Duopoly is as market structure comprises of only two
firms.

There are two types of oligopoly: 1. Non - collusive oligopoly, and 2. Collusive oligopoly

If there are two firms in the market, there are four variables: P1, P2, Q1 and Q2. And there are
different scenarios under which a firm makes decisions regarding these four variables depending
on the type of oligopoly. If the oligopoly is non-collusive type,
- The firm might be price leader (set price before the other firm).
- The firm might be price follower
- The firm might be quantity leader (choose quantity level first than the other firm)
- The firms might be quantity followers
The strategic interactions in these cases form a sequential game. And if the oligopoly is of
collusive type, the firms set price and quantity levels simultaneously and independently.
Collusive oligopoly is when firms jointly agree to determine price and/or quantity so as to
maximize sum of their profit.

2.1 Non- collusive Oligopoly

We examine four types of non-collusive oligopoly:

- Kinked demand model
- Cournot’s duopoly model
- Bertrand’s duoploly mdel
- Stackelberg’s duopoly model

I. Kinked Demand Model

- Kinked demand model is emerged as a tool of analysis from the intersection of Chamberlin
market share curve (D) and expected sales curve (d) where now the model is applied to small
number of firms.
- It was Sweezy (1939) who used this model for determination of equilibrium in oligopolistic
market (where decisions consider the action of other firms).
- The kinked demand curve is the result of the expectation that the competing firms will follow
price cuts by an individual firm but not price increase.
- If the firm reduces price below P, the firm expect that the other firms will do the same. This
reduction in price increase the market demand but the share of each competitor remain the
same. Thus for price reduction below P (which correspond to point of kink), the share of the
market demand curve is the relevant demand curve. But above price level P, if the firm

2
 increases price, the other firms will not follow suit so that the firm lose some of its
customers.

- Ed is flatter than ED which shows

P D’ that Ed is more elastic than ED.
MR d - At point E, since the slope is
undefined the MR curve will be
P E discontinuous.
MC1
A MC2 Where should be the equilibrium?
d’ - To the left of the kink MR>MC and
B D to the right of the kink MR< MC. So,
equilibrium should be at the kink.
0 Q Q
MR

- Here it is not possible to determine equilibrium by marginalistic equalization of MR and MC.

In general the MC curve passes through the discontinuous AB. The discontinuity (between A and
B) is a range within which costs may very without affecting price and quantity of the firm. The
kink explains why firms keep their price and output constant while their cost structure is
changing. But if the rise in cost affects all firms equally and the firm is aware of this, then it can
certainly expect that the other firms will follow to simultaneously raise price and equilibrium
will shift up.

P - The equilibrium will be at a

higher price and lower output
P’ E’
level.
P E
A’ - The kink shifts up to the left.
A
B’
B D

Q’ Q Q
MR

Furthermore, there is a range through which demand may shift without change in price though
quantity will change. If the demand curve is kinked, a shift in the market demand upwards or

3
downwards will affect the volume of output but not the level of price so long as the costs passes
within the ranges of the discontinuous of the MR.
If there is increase in market demand, the demand curve shifts upward and will change the
equilibrium level of output but not the price level as long as the cost passes through the
discontinuity of the new MR.

P - The shift in demand occurs

along the same price line.
D’
A A’ D
B B’

Q’ Q Q
MR MR’

The kinked demand model explains why price remain the same (sticky) in the face of changing
costs or demand but it does not very well explain at which price kink will occur. The kink is the
consequence of the uncertainty of the oligopolists and of their expectations that competitors will
match price cuts but not price increases. Hence, it is not a theory of pricing , but rather a tool
for explaining why the price, once determined in one way or the other, will tend to remain fixed.
However, this model does not explain the price and output decisions of the firms. It does not
define the level of price that maximizes profits. The kinked demand curve can explain the
‘stickiness’ of prices in a situation of changes in costs and of high rivalry.

II. Cournot’s Duopoly Model

Suppose that two firm 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 for
itself. In this section, 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 ask an equilibrium in forecasts: a situation where each firm finds its beliefs
about the other firm to be confirmed.

In this model a firm is consider as trying to forecast its rival’s output before it makes decisions
about its optimal output. Given this forecast it chooses the profit maximizing output for itself.
Suppose two firms produce identical products (there is no products differentiation). If firm 1
expects firm 2 to produce then it expects the total market supply to be Q Q . And
price will be a function of the total quantity available for sale, Q .

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The profit maximization problem of firms 1 is maximization of Q TC given expected
output of firms 2, ( ). Given any belief about firm 2’s output , there will be specific
optimal output for firm 1 (i.e., Q ).

The Functional relationship between and optimal output choice of firm one is called reaction
function of firm 1 which is given as . The reaction function presents firm’s optimal
choice as a function of its beliefs/expectation about firm 2’s output.

Similarly firm 2 solve its profit maximization problem given expected output of firm 1, ( ).
The functional relationship between and the optimal quantity of firm 2 is called reaction
function of firm 2 given as .

The reaction function for the firms will be derived from the isoprofit functions and the reaction
curves are derived from the isoprofit curves. Consider a simple linear inverse market demand

For simplicity assume that cost of production equals zero.

Profits for firm 1 is,

The isoprofit curves can be constructed by taking different value for . The isoprofit curve for
firm 1 is the locus of different combinations of and which yield the same level of profit to
firm 1.
Profit for firm 2:

The isoprofit curve for firm 2 can be drawn by taking different combinations of and which
give the same level of profit.
is a deceasing function of and is a decreasing function of .

Solve the reaction functions for the two firms ….

…. follow class lecture

The further the isoprofit curves (for substitute commodities) lie form the axes, the lower is the
profit. And the closer to the quantity axis an isoprofit curve lies, the higher the profitability of the
firm is.

5
Reaction curves are derived from the isoprofit maps of each firm. The isoprofit map for firm 2
can be constructed by taking different values for . increases as one gets closer to axis.

Q2
Isoprofit lines
for firm 2
Firm 2’s
reaction
curve,

q1 q2 q3 q4 Q1
Isoprofit map of firm 2

Given any expectation about output of firm 1, firm 2 tries to set its output such that its profit is
the maximum possible. This is attained when a vertical line through the expected output of firm
1 is tangent to the left most isoprofit curve of firm 2. The locus of such tangency points defines
the reaction curve of firm 2, given output choice of firm 1. The locus of maximum profits of firm
2, given output choice by firm1. The reaction curve is negatively sloped because π is a
negative function of Q .

Similarly, for any given output that firm 2 may produce, there will be unique level of output for
firm 1 which maximizes the latter’s profit. This unique profit-maximizing level of output will be
determined by the point of tangency of the line through the given output of firm 2 and the lowest
attainable isoprofit curve of firm 1. In other words, the profit- maximizing output of firm 1 (for
any given quantity of 2) is established at the highest point on the lowest attainable isoprofit curve
of firm1. The locus of such points defines the reaction curve of firm 1, given output choice of
firm 2. The locus of maximum profits of firm 1, given output choice by firm 2. The reaction
curve is downward sloping because is a decreasing function of .

6
 Firm 1’s
Q2 Q2 reaction curve,

Isoprofit lines
for firm 1
q3
q2
q1

Isoprofit map of firm 1 Q1

Cournot’s Equilibrium

The reaction curve shows how the firm will react to the output choices of the other firm. In
Cournot’s model, it is assumed that a firm expects the other firm to keep its output constant
while making its optimization decisions. Each firm acts independently under the assumption that
the other firms will not react under similar behavioral pattern. Under these assumption a stable
equilibrium is established when the reaction curves of the two firms intersect each other. The
intersection point of the reaction curve is the only point at which each firm will find its
expectation about the other firm’s output confirmed.

Q2
Firm 1’s reaction curve

B1
B2 e
Q2* Firm 2’s

A1 A2 Q1* Q1

Cournot’s equilibrium is determined by the intersection of the two reaction curves. It is a stable
equilibrium. To see that, let us examine the situation arising from firm 1’s decision to produce
quantity A1, lower than the equilibrium quantity Q1*. Firm B will react by producing B1 given
the Cournot assumption that firm 1 will keep its quantity fixed at A1. However, firm 1 reacts by
producing a higher quantity, of A2, on the assumption that firm 2 will stay at the level B1. Now
firm 2 reacts by reducing its quantity to B2.This adjustment will continue until point e is reached.
The same equilibrium would be reached if we started from a point to the right of e. Thus e is a
stable equilibrium.
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What will be the values of Q1* and Q2*? To get the equilibrium quantities, solve the reaction
functions of the two firms simultaneously.

…… follow class lecture

Note that when firms act independently the industry’s profit is not maximized. Industry profit
could be made higher if the two firms were to act jointly (i.e., through collusion).
…… follow class lecture
Different combination of Q1 and Q2 which maximize industry profit constitute what is called a
contract curve for the industry. The contract curve is obtained by connecting the points of
tangency between the isoprofit curves of the firms (the point at which marginal profit are
equalized across firms).
Point E is Cournot’s equilibrium.
Q2 - At point A, firm one will
Π21 Π22 Π23 Π24 continue to earn the same level
of profit but firm 2 will get a
higher profit.
- At point B, firm 2 will earn the
same profit but firm 1 will have
E
E a higher profit level.
A C
B

Π11 Π12 Π13 Π14 Q1

So if the firms move from point ‘e’ to a point between ‘A’ and ‘B’ the firms will get higher profit
levels. But the firms will be at the suboptimal equilibrium point ‘e’ due to the behavior of the
firms.

Each firm expecting that the other firm to remain at a given level output, it adjusts its optimal
output level. But each firm act with the same behavioral pattern which leads to point ‘e’.

Cournot’s pattern of behavior implies that the firms do not learn from past experience, each
expecting the other to remain at a given position. Each firms acts independently, in that it does
not know that the other behaves on that same assumption.

III. Bertrand’s Duopoly Model

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Here each firm expects that the rival will keep its price constant irrespective of its own decision
about pricing. Hence each firm tries to solve its profit maximization problem given the price of
the other firm .

The functional relationship between the forecasted level of rival’s price and the optimal price
level is given as a reaction function.

And the locus of different prices of firm 1 and firm 2 which yield the same level of profit gives
isoprofit curves. The isoprofit curves are convex to the price axis of the firm. The slope shows
the fact that the firm will have to lower its own price until a certain price point (e) and expand
sale to maintain profit at a certain level while the other firm is reducing price.

However, after that price level has been reached and if firm 2 continues to cut its price, firm 1
will be unable to retain its profits, even if it keeps its own price unchanged (at P1e). If, for
example, firm 2 cuts its price at P1, firm 1 will find itself at a lower isoprofit curve (π ) which
shows lower profits. The reduction of profits of firm 1 is due to the fall in price, and the increase
output beyond the optimal level of utilization of the plant with the consequent increase in costs.
Clearly the lower the isoprofit curve, the lower the level of profit.

For any price charged by firm 2 there will be a unique price for firm 1 which maximizes the
latter’s profit. This unique profit –maximizing price is determined at the lowest points on the
highest attainable isoprofit curve of firm 1. The minimum points of the isoprofit curves lie to the
right of each other, reflecting the fact that as firm 1 moves to a higher level of profit, it gains
some of the consumers of firm 2 when the latter increases its price even if firm 1 also raises its
price. If we join the lowest points of the successive isoprofit curves we obtain the curve of firm
1: this locus of points of maximum profits that firm 1 can attain by charging a certain price,
given the price of its rival.

Firm 1’s
reaction
curve,

9
 P2

Π3
Π2
P3 Π1

P2 e
P1

P1e P1

For any given price of firm 2, firm 1 will have a unique profit maximizing price. This profit
maximizing price is determined at the lowest points of the highest attainable isoprofit curve of
firm 1.
The functional relationship between price of firms 2 and optimal price level of firm 1 is given by
reaction function. The reaction curve of firm 1 can be obtained by joining the minimum points of
the isoprofits curve (the points of tangency between a horizontal line through expected price of
firm 2 and the isoprofit curve of firm 1.

Similarly, the reaction curve of firm 2 is derived by joining the lowest points of firm 2’s isoprofit
curves (or by connecting the point of the tangencies between the vertical line through the
expected price of firm 1 and isoprofit curves of firms 2).

P2

Π1 Π2 Π3

P1

The reaction curves are positively sloped because profit of a firm is an increasing function of the
other firm’s level of price.

Bertrand’s Equilibrium

10
The reaction curve for a firm under Bertrand’s price competition shows how the firm will react
to the price decisions of its rival. Bertrand assumed that a firm expects its rival to keep is price at
the current level. Bertrand’s stable equilibrium is attained at the intersection of the reaction
curves of the duopolists because any others situation will be unstable.

- Any point other than ‘e’ is not

P2 stable.
- If firm 1 charges a1, firm 2
will charge b1 amount. And to
be e this, firm 1 reacts by charging
a2 amount.
b2 - This process continues until
b1 equilibrium at point ‘e’ is
maintained.

a1 a2 ae
P1

When firms operate under Bertrand’s assumption selling homogeneous product, equilibrium will
turn out to be competitive market equilibrium (P = MC). This is so because when a firm expects
its rival to keep its price constant, it will have an incentive to undercut the price of its rival and
attract all customers. Both firms are likely to try to undercut each other’s price. The price
competition is likely to continue until P = MC.

Example: …. follow class lecture

IV. Stackelberg’s Duopoly Model

This applies to a situation where there exists one dominant firm that makes output choice before
other firm (quantity leadership which is an extension of Cournot’s model) who recognized that
his competitor acts on the Cournot assumption. This recognition allows the sophisticated
duopolistic to determine the reaction curve of his rival and incorporate it in his own profit
function , which he then proceeds to maximize like monopolist.

If firm 1 is the sophisticated oligopolist, it will assume that its rival will act on the basis of its
own relation curve. This recognition will permit firm 1 to choose to set its own output at the
level which maximizes its own profit. This is point ‘a’ which lies on the lowest possible isoprofit
curve of firm 1, denoting the maximum profit firm 1 can achieve given firm 2’s reaction curve.
Firm 1, acting as a monopolist (by incorporating firm 2’s reaction curve in his profit maximizing
computations), will produce Q1A and firm 2 will react by producing Q2A according to its reaction

11
curve. The sophisticated oligopolist becomes in effect the leader, while the naive rival who acts
on the Cournots assumption becomes the follower.

Given the reaction function of the follower firm, firm 1 maximizes its profit by operating on the
isoprofit curve that represents the highest possible profit for itself. This is attained when the
reaction function of firm 2 is tangent to the isoprofit curve of firm 1. This is called Stackelberg’s
equilibrium when firm 1 is a dominant leader and firm 2 is a Cournot’s follower.

If firm 2 is dominant leader and firm 1 is Cournot’s follower, Stackelberg’s equilibrium will be
at the point of tangency of the reaction curve of firm 1 and the profit curve of firm 2.

Firm 2 will have larger profit

Q2 Stackelberg’s equilibrium when
and firm 1 will have lower
firm 2 is the sophisticated leader
b profit as compared to
Cournot’s equilibrium.

Cournot’s Equilibrium
e Firm 1 gets higher
Stackelberg’s profit and firm 2 lower
Q2a a equilibrium when profits as compared to
firm 1 is the Cournot’s equilibrium.
sophisticated leader
Q1a Q1

In summary, if only one firm is sophisticated, it will emerge as the leader and a stable
equilibrium will emerge, since the naive firm will act as a follower. The leader takes a larger
share of the market and profit. In such a situation the Stackelberg’s equilibrium will be stable if
and only if there is one dominant firm. However, if both firms think that they are dominant,
instability will occur because both firms will look for the larger share of the market.

In the instability, there may be price war until one surrenders and agrees to be follower; or the
firms may create collusion. If the firms collude, equilibrium will be on the contract curve on
which industry profit is maximized.

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 Q2 Cournot’s
equilibrium

b
Contract
curve
e

Q1
If the rivals recognize their interdependence, each firm can be at higher profit level by operating
on the contract curve. If each ignores the other, a price war will be inevitable. This is destructive
for both firms as a result of which both will be worse off.

The Stackelberg’s model shows that a bargaining procedure and a collusive agreement becomes
advantageous to both firms. With such collusive agreement the duopolistis may reach a point on
the contract curve attaining joint profit maximization

Example: … follow class lecture

2.2 Collusive Oligopoly

One way of avoiding the uncertainty arising from oligopolistic interdependence is to enter into
collusive agreements. There are two main types of collusion: cartels and price leadership. Both
forms generally imply tacit (secret) agreements, since open collusive action is commonly illegal
in most countries at present.

2.2.1 Cartels

Cartel is an association of producers who agree to fix common price and outputs quotas in an
oligopolistic market. As the aim of a carter is to prevent competition, there is a tendency for the
producers to strive to maintain existing market shares, with the consequence that a firm can only
increase its output if total market demand rises. When firms get together and attempts to set
prices and outputs so as to maximize total industry profits, they are known as a cartel. A cartel is
simply a group of firms that jointly collude to behave like a single monopolist and maximize the
sum of their profits.

The two typical forms of cartel are

A. Joint – profit maximization cartel

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 B. Market sharing cartel

A. Joint – Profit Maximizing Cartel

Firms agree to maximize group (industry) profits by jointly determining the industry output and
the price at which it is sold and the share of each member on the industry output. This
maximization procedure is identical to multi-plant monopolist. We focus on an oligopoly where
all firms produce homogeneous product.
- For simplicity we assume that there are only two firms in the cartel.
- The profit maximizing output is determined by the intersection of MR and aggregate MC
curve. The aggregate MC is obtained by the horizontal summation of individual firm’s MC
curves.
- The total output will be shared by the member firms by equating the individual firms MCs to
the MR at the industry equilibrium, i.e., MC1 = MC2 = MR
- Note that the firm with lower costs produces a larger amount of output. However, this does
not mean that the firm will also take the larger share of the attained join profit. The total
profit is the sum of profits from output of the two firms. The distribution of profits will be
determined by agreement between the two firms.

MC1 MC2
AC1 AC2 MC=MC1+MC2

P P P

e1 e2 MC=MR e D

0 Q1 0 Q2 0 Q = Q1+Q2 Q
MR

We found from Cournot’s model that industry’s profit is maximized along the contract curve.
Contract curve equation gives us different combination of Q1 and Q2 that maximize cartel profit.

14
 Q2

Contract
curve
e
2

Q1

Example: … follow lecture note

Mergers

An amalgamation of two or more firms into a new firm. A vertical merger occurs when firms in
industries at different stages of bringing a good to the final consumer, i.e., extractive,
manufacturing or distribution, join together. It the firms are in the same industry there is a
horizontal merger. A conglomerate merger is an amalgamation of firms with dissimilar activities.

A merger involves the decision of number independent firms to form a single corporation. The
new firm may act as carrel. The decision of a merger is the same as joint profit maximizing
cartel. The new firm (which is formed from number of firms producing the same products), act
like a cartel. Output level for each plant will be decided by the equality of the marginal cost to
the common MR.

Under these conditions the difference between a cartel and a manger is only a legal one: while
overt (open) cartel agreement is illegal in Britain and the U.S.A., mergers are generally legal. A
merger can be forbidden only if it is proved that its aim is to restrict competition and earn
abnormal monopoly profits. However, mergers are usually rationalized on the grounds of better
utilization of resources and attainment of economies of scale, and thus are allowed to take place
more often than not.

B. Market Sharing Cartels

This form of collusion is more common in practice because it is more popular. Here the firms
agree to share the market but keeps considerable degree of freedom regarding product style,
selling strategies and other decisions.
There are two ways of sharing the market:
(i) Non- price competition
(ii) Determination of quotas

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(i) Non - price competition

- It is not a strong cartel as compared to a joint profit maximizing cartel.

- In the non-price competition, firms agree on a common price level but firms can sell any
quantity demanded.
- Firms do not have any limitation on the quality, style or selling strategies of their products.
- So firms will be competition in other characteristics (i.e. they compete in non- price basis)
- How is the price level determined? There price level is determined by bargaining
(negotiation). The high cost firm negotiates for high price level and the low cost firm
negotiates for low price level. Agreement will be reached on price level which gives some
amount of profit for each firm.
- But this is unstable because the firm with low cost will have an incentive to cheat and lower
price level.
- Soon it will be known by the other firm because the firm will lose his customers. Then, the
firm will react on one of the following two alternatives:
1. There may be price war until only the stronger firm with low cost stay in market.
2. The other firms altogether may engage in price war with the one who has cheated
until the cheated is driven out business. The successfulness of this strategy depends
on:
- The cost differential of the cheater and the other cartel members.
- The capacity of the members to finance possible losses during the price war.

If all firms agree to charge a common price the price will be monopoly price i.e. Pm

MC1
AC1

Pm Pm Pm
MC2
AC2 D
PB

MRA MRB
0 QA 0 QB 0 Q = QA+QB Q
MR
Firm A Firm B Industry

At price level Pm, both firms get positive profit level. But firm B has incentive of lowering price
to PB and driving out the high cost firm i.e. firm A. This is because at PB, for firm A, the AC is
greater than the price level.

16
Not only when firms have different costs but also when firms have the same cost the cartel is
unstable. Those firms with the same cost will have an incentive to lower their price level than the
monopoly price because if one firm splits away and charges a slightly lower price than the
monopoly price Pm while the others remain in the cartel, the splitting firm will attract a
considerable number of consumer from the others: its demand curve will be much more elastic
and its profit will be increased. Thus the cartel will be unstable. However, it can be made stable
with legislation.

(ii) Sharing of the market by agreement on Quotas

Here the firms will agree on the quantity that each member may sell at the agreed price. If the
two firms have identical costs, the market will be shared equally at the monopoly price. The
monopoly price is Pm and the quotas which will be agreed are QA = QB = ½ (Q). But if the costs
are different, the quotas and shares of the market will differ.

Similar to the above case the cartel is unstable under different costs of production. Quota shares
will be determined by bargaining. During the bargaining process two main statistical criteria are
most often adopted: quotas are decided on the basis of past level sales and on the basis of
‘productive capacity’. The past- period sales and/or the definition of ‘capacity’ of the firm
depend largely on their bargaining power and skill.

MC =
MCA+MCB
Pm Pm Pm

D= D1+D2
MRA D1 MRB D2
0 QA 0 QB 0 Q = QA+QB Q
Firm A Firm B Industry MR

Another way of sharing the market is by defining the region that each firm is allowed to sell. In
the geographical areas the price as well as the style of the products may differ. However, even a
regional split of the market is inherently unstable. The regional agreement are often violated in
practice, either by mistake or intentionally by the low-cost firm who have always the incentive
to expand their output by selling at a lower price openly defined, or by secret price concessions,
or by reaching adjacent markets through advertising. Therefore, this form of market sharing is
also unstable.
- Untill now the cartels are closed. If entry is allowed, the instability will increase as the
behavior of the new entrant is not known.

17
Generally, there are factors that affect the share of a firm in the total market output: cost
differences, productive capacity, past level of sales and geographic proximity.

2.2.2 Price Leadership

In this form of coordinated behavior of oligopolists, firms adopt the price set by a leader. But
why the other firms follow the price leader?
- To avoid the uncertainty about the firms reactions even if this implies departure of
the followers from their profit maximizing position.
- Because it is advantageous to them for they cannot compete with the leader.
Formally or informally (usually informally) price leadership exists.
- If firms have homogeneous product in the same market there will be the same price.
- If firms have differentiated products in the same locality, there will be differentiated prices
but the direction of price change will be similar i.e. if the leader increases the price, the
follower increases the price.
There are various forms of price leadership. The most common types are: price leadership by a
low cost firm and price leadership by a large or dominant firm.

(i) Price leadership by low-cost firm

There are two firms that produce homogeneous product at different costs, which clearly must be
sold at the same price. They may share the market equally or unequally. In the cases of cost
differences the high cost firm may agree to adopt whatever price the lowest cost firm sets in the
market because it is impossible to compete with this kind of firm.

The low cost firm sets price at MR=MC level for itself. The high cost firm adopts this price level
even if it does not maximize its profit.

Consider two firms producing homogenous product with different costs. The product will be sold
at the same price level for reach firm. The two firms may share the market equally or may have
unequal shares.

Firms sharing the market equally

When the firms have identical demand curve the market will be shared equally.

18
 P P
C C
MC2 P2 MC2 AC2
P2 AC2 P1 MC1
P1 AC1

MC1 d1
AC1 D market
d2

D MR2 MR1
Q’2 Q2 Q1 Q
Q’2 Q1=Q2 Q=Q1+Q2 Q
MR1=MR2 Low-cost price leader Firms with unequal market share
Low-cost price leader Firms with equal market share

The low cost firm (firm 1) set the price level P1 by the equalization of MR1 =MC1 the high cost
firm (firm2) will adopt this price even though it will not maximize profit of the firm. For the
high-cost firm profit is maximum when the firm charges P2 (higher Price) and reduce quantity to
Q’2. But the high-cost firm prefers to follow the low cost firm in order to avoid price war (see
the above figure to the left).

Firms sharing the market unequally

When the firms have different demand curves, the market will be shared unequally. The low cost
firm (firm 1) determines the price level, P1, by equating MR1 to MC1. The high-cost firm
follows this price level and supply Q2 amount but this is not a profit maximizing level. Profit for
the high cost firm will be maximum at price level of P2 i.e. price level determined by
MR2=MC2 (see the figure to the right).

Example: … follow class lecture

B. Dominant Firm Price Leadership

This is a model when there exists one large and dominant firm with a considerable market share
and some other smaller firms with small market share. The market demand is assumed known to
the dominant firm.

The smaller firms may think that it is difficult to compete with the dominant firm and may
simply adopt whatever price it sets in the market. The smaller firms take the price determined by
the dominant firm as given and maximize profit by equating it (the price) to their MC. The small
firms are price takers.

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The dominant leader is assumed to know the supply of each firm at each price level. And the
dominant firm can determine total output supplied by all small firms by adding horizontally each
firm supply. Therefore, at each price level the dominant firm can sell the part of the market
demand that could not be satisfied by the smaller firms.

P D Sf P
P1 D’
P1
Small firms
supply MC
PL PL AC
a b C
leader’s supply

P3 dL
D

0 Qf Q q QL MR q

At price P1, the demand for the product of the leader will be zero because the total quantity
demanded is supplied by the smaller firms.

The demand for the dominant leader firm at each price is the difference between the market
demand and the supply of the smaller forms. dL = D - Sf, where dL= demand of dominant leader,
D = market demand and Sf = supply of small firms.

- Sf is the horizontal summation of the MCs of each firm.

At price PL, the total market demand is ‘ac’ and part of it i.e. ‘ab’ amount is supplied by small
firms and the remaining by the dominant firm i.e. bc = 0Q - QL. Once the dominant firm
determine its residual demand (dL) and given his MC curve the leader sets price using its MC=
MR condition to maximize profit. Accordingly, the leader sets rice at PL and sells QL.

The smaller firms adopt the same price (PL) and sells Qf. The smaller firms are price takers who
may or may not maximize their profits depending on their costs structure. If the small firms got
maximum profit, it is not due to the actions of these firms. It is only by accident.
Market output (Q) = QL + Qf

Mathematically … follow class lecture

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