Chapter TWO

CHAPTER Three

OLIGOPOLY MARKET STRUCTURE

Definition: The term oligopoly is derived from two Greek words: ‘oligi’ means few and ‘polein’
means to sell. Oligopoly is a market structure in which there are only a few sellers (but more than
two) of the homogeneous or differentiated products. So, oligopoly lies in between monopolistic
competition and monopoly.

Oligopoly refers to a market situation in which there are a few firms selling homogeneous or
differentiated products. Oligopoly is, sometimes, also known as ‘competition among the few’ as
there are few sellers in the market and every seller influences and is influenced by the behavior of
other firms.

DUOPOLY is a special case of oligopoly, in which there are exactly two sellers. Under duopoly, it
is assumed that the product sold by the two firms is homogeneous and there is no substitute for it.
Examples where two companies control a large proportion of a market are: (i) Pepsi and Coca-Cola
in the soft drink market; (ii) Airbus and Boeing in the commercial large jet aircraft market; (iii) Intel
and AMD in the consumer desktop computer microprocessor market.

Types of Oligopoly:
1. Pure or Perfect Oligopoly:
If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though, it is
rare to find pure oligopoly situation, yet, cement, steel, aluminum and chemicals producing
industries approach pure oligopoly.

2. Imperfect or Differentiated Oligopoly:

If the firms produce differentiated products, then it is called differentiated or imperfect oligopoly.
For example, passenger cars, cigarettes or soft drinks. The goods produced by different firms have
their own distinguishing characteristics, yet all of them are close substitutes of each other.

3. Collusive Oligopoly:
If the firms cooperate with each other in determining price or output or both, it is called collusive
oligopoly or cooperative oligopoly.

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4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non-collusive or non-
cooperative oligopoly.

Basic Features of Oligopoly

The main features of oligopoly are elaborated as follows:

1. Few firms:
Under oligopoly, there are few large firms. The exact number of firms is not defined. Each firm
produces a significant portion of the total output. There exists severe competition among different
firms and each firm try to manipulate both prices and volume of production to outsmart each other.
The number of the firms is so small that an action by any one firm is likely to affect the rival firms.
So, every firm keeps a close watch on the activities of rival firms.

2. Interdependence: Firms under oligopoly are interdependent. Interdependence means the actions
of one firm affect the actions of other firms. A firm considers the action and reaction of the rival
firms while determining its price and output levels. A change in output or price by one firm evokes
reaction from other firms operating in the market.

3. Non-Price Competition:
Under oligopoly, firms are in a position to influence the prices. However, they try to avoid price
competition for the fear of price war. They follow the policy of price rigidity. Price rigidity refers
to a situation in which price tends to stay fixed irrespective of changes in demand and supply
conditions. Firms use other methods like advertising, better services to customers, etc. to compete
with each other. If a firm tries to reduce the price, the rivals will also react by reducing their prices.
However, if it tries to raise the price, other firms might not do so. It will lead to loss of customers
for the firm, which intended to raise the price. So, firms prefer non- price competition instead of
price competition.

4. Barriers to Entry of Firms:

The main reason for few firms under oligopoly is the barriers, which prevent entry of new firms into
the industry. Patents, requirement of large capital, control over crucial raw materials, etc, are some
of the reasons, which prevent new firms from entering into industry. Only those firms enter into the

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industry which is able to cross these barriers. As a result, firms can earn abnormal profits in the long
run.

5. Role of Selling Costs (Advertising outlays):

Due to severe competition ‘and interdependence of the firms, various sales promotion techniques
are used to promote sales of the product. Advertisement is in full swing under oligopoly, and many
times advertisement can become a matter of life-and-death. A firm under oligopoly relies more on
non-price competition. Selling costs are more important under oligopoly than under monopolistic
competition.

6. Group Behavior: Under oligopoly, there is complete interdependence among different firms. So,
price and output decisions of a particular firm directly influence the competing firms. Instead of
independent price and output strategy, oligopoly firms prefer group decisions that will protect the
interest of all the firms. Group Behavior means that firms tend to behave as if they were a single
firm even though individually they retain their independence.

7. Nature of the Product:

The firms under oligopoly may produce homogeneous or differentiated product.

i. If the firms produce a homogeneous product, like cement or steel, the industry is called a pure or
perfect oligopoly.

ii. If the firms produce a differentiated product, like automobiles, the industry is called differentiated
or imperfect oligopoly.

8. Indeterminate Demand Curve:

Under oligopoly, the exact behavior pattern of a producer cannot be determined with certainty. So,
demand curve faced by an oligopolist is indeterminate (uncertain). As firms are inter-dependent, a
firm cannot ignore the reaction of the rival firms. Any change in price by one firm may lead to
change in prices by the competing firms. So, demand curve keeps on shifting and it is not definite,
rather it is indeterminate.

3.1 Non Collusive Oligopoly

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Non collusive oligopoly assume that there is no collusion or any form of agreement between the
sellers to act jointly towards price, market share, or competition collusive models, on the other hand,
collusive oligopoly assume some kind of agreement between the sellers under certain system.

3.1.1. Cournot’s Duopoly Model (Quantity Competition)

The model of pricing put forward by Augustin Cournot in 1838 is a duopoly model (existence of
only two firms in the market). Cournot’s model assumes that there are only two firms in the
market – A and B – each one producing mineral water at zero cost (This is because each of the firms
is assumed to be owning a spring of mineral water). In other words, the model is based on
following assumptions.

1. two firms (duopoly model )

2. Mc=0
3. Each firm has its own reaction curve or best response curve
4. No reaction for change in price or output.
5. Both firms don’t learn from their past experiences.
6. Simultaneous game.
7. Non-price competition
8. Simultaneous output decisions by all firms

Suppose there are two firms in the industry (duopoly): Firm 1 and Firm 2, producing q1 and q2,
respectively. The market output is Q= q1+ q2

• Firm 1’s Reaction function: q1=f (q2)

• Firm 2’s Reaction function: q2=f(q1)

Graphical Illustration: Consider two firms Firm 1 and Firm 2

Quantity for Firm A

qA Firm B’s reaction function

Cournot equilibrium

qA Firm A’s reaction function

0 qB qB Quantity for firm B

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  Firm A’s reaction curve shows how much it will produce as a function of how much it thinks
Firm B will produce.
 Firm B’s reaction curve shows how much it will produce as a function of how much it thinks
Firm A will produce

Numerical example:-

Given these assumptions, one firm reacts to what it believes the other firm will produce. In other
words, if firm B produces qB of output, what quantity should firm A produce? The Cournot
reaction function describes the relationship between the quantity firm A produces and the quantity
firm B produces. Here’s how it works.
The market demand curve faced by Cournot duopolies is:
P = 120 – 0.5QD

Where QD is the market quantity demanded and P is the market price in dollars.
Assuming firm A has a constant marginal cost of $20 and firm B has a constant marginal cost of
$34, the reaction function for each firm is derived by using the following steps:
1. Note that the market quantity demand, QD, must be jointly satisfied by firms A and B.
Thus,
QD = q A + q B

2. Substituting the equation in Step 1 for QD in the market demand curve yields
P = 120- 0.5(qA +qB) = 120-0.5qA – 0.5qB
3. For firm A, total revenue equals price multiplied by quantity.
TRA = Px qA = (120-0.5qA- 0.5qB)x qA = 120qA – 0.5q2A – 0.5qBqA
4. Firm A’s marginal revenue is determined by taking the derivative of total revenue, TRA, with
respect to qA. Remember to treat qB as a constant because firm A can’t change the quantity of
output produced by firm B.
𝑑𝑇𝑅𝐴
MRA = = 120-qA-0.5qB
𝑑𝑇𝑞𝐴
5. Firm A maximizes profit by setting its marginal revenue equal to marginal cost. Firm A’s
marginal cost equals $20.
MRA = 120-qA-0.5qB=20 =MCA
6. Rearranging the equation in Step 5 to solve for qA gives firm A’s reaction function.
120-20-0.5qB = 100-0.5qB = qA (Firm A’s reaction function)
7. Repeat Steps 3 through 6 to determine firm B’s reaction function.
Remember that firm B’s marginal cost equals $34.
TRB=PxqB =(120-0.5qA-0.5qB) x qB =120qB-0.5qAqB-0.5q2B

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 𝑑𝑇𝑅𝐴
MRB = =120-0.5qA –qB
𝑑𝑇𝑞𝐴
MRB = 120-0.5qA-qB = 34 =MCB

120-34-0.5qA =86-0.5qA = qB (Firm B’s reaction function)

8. Substituting firm B’s reaction function for qB in firm A’s reaction function enables you to solve
for qA.
100-0.5qB =100-0.5(86-0.5qA) = qA
100-43+0.25qA = qA
57= 0.75qA or qA = 76
9. Substituting qA = 76 in firm B’s reaction function enables you to solve for qB.
86-0.5qA = 86-0.5(76) = 48 qB = 48

Thus, in the profit maximizing Cournot duopolist, firm A, produces 76 units of output while firm
B produces 48 units of output.

Note: In the Cournot duopoly model, both firms determine the profit-maximizing quantity
simultaneously. In this example, firms A and B had different marginal costs. If the firms have the
same marginal costs (MCA = MCB), each firm produces half the market output.

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Criticism of Cournot’s Model :
Cournot’s duopoly model, expressing the limiting case of Oligopoly, is criticized on many grounds.
Following are some of the important ones:
a) Assumption of costless production is highly unrealistic.
b) It is a ‘closed’ model where there is no entry for new firms.
c) In each successive period, price is brought down by the action-reaction pattern of two firms.

3.1.2 The Kinked Model

This is the best known model to explain, relatively more satisfactorily, the behavior of oligopolistic
firms. The kinked demand curve analysis does not deal with price and output determination. Rather
it seeks to establish that once a price-quantity combination is determined, an oligopoly firm will not
find it profitable to change its price even in response to the small changes in the cost of production.
But, there are four possible cases for the action and reaction of firms in general.

a) If rival firms follow the price change both cut and hike, the leader firm will move its demand
curve dd' and it does not gain or lose.
b) If rival firms do not follow the price change, its demand curve will be DD' ,and it loses
during price hike and gains during price cut.
c) If rival firms follow during price cut and do not follow during price hike, the demand curve
will be DP for the cut and Pd' for the hike. These two together will form the kinked demand
curve. DA is the marginal revenue curve associated with the demand curve DP and BC is
the marginal revenue curve associated with the demand curve Pd'. Therefore, the marginal
revenue curve is discontinuous at Q. Because it is drawn on the basis of the relationship
MR=AR-AR/Ed. At equilibrium MC1=MR1 or MC2=MR2. The equilibrium is stable enough
that change in cost by the extent of AB will not disturb it.

Price
D d MC2

P MC1
MR1
A
B d' D'
C MR2
O Qe
Fig. Equilibrium of oligopoly of firms under normal condition

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 d) If rival firms follow during price-hike and do not follow during price cut, the demand curve
would be DP for the rise and Pd' for the cut. The marginal revenue curves associated with
the demand curves DP and Pd' are AB and CD respectively. The point of intersection for the
marginal cost to these marginal revenues create multiple price (two price levels) and multiple
output (two output levels ) so that no unique and stable equilibrium. While some firms would
like to raise the price, others would prefer to reduce their prices. This kind of firms’ behavior
makes the market condition unstable and price and output become uncertain.

Shortcomings of this model

1. Since MC can shift up and down between point A and B (in fig.1.33), MR remaining the
same, Sweezy’s model deviates from the Marginal Productivity Theory, i.e. factor prices do
not equal their marginal revenue product.

2. According to Sweezy’s model, any short term disturbance in MC will not affect the
equilibrium price and output and the total profit (in fig.1.33). This conclusion conflicts with
the general fact that a successful strike by trade unions reduces the output and profits.

3. It explains only the stability of output and price. It does not tell, why and how the initial
price is fixed at a certain level.

4. Sweezy’s claim of price stability does not stand the test of empirical verification. There are
also some economists who questioned even the existence of kinked demand curve.

3.1.3. Bertrand’s Duopoly Model

Developed by Joseph Bertrand (1883)

 It is a “Price competition” model

Assumptions of the model:

There are two firms in the market

Firms sell homogeneous products
No cooperation among firms
Firms compete by setting prices simultaneously
Consumers buy everything from the low price firm
Marginal cost=c for both firms

Firms satisfy the demand-no capacity constraints

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 The quantity demanded for firm A and firm B is a function of both the price the firm establishes and
the price established by their rival because the goods are highly substitutable. Thus, the firms have
the following demand curves relating quantity demanded to its price and its rival’s price.

Example:- Let’s take two firms A and B as follows:

Firm A; qA = 400-4PA +2PB

FirmB: qB = 240-3PB + 1.5PA

To simplify the analysis, assume that both firms have zero marginal cost for their products. Profit
maximization then requires each firm to choose a price that maximizes its total revenue.

Derive the Bertrand reaction functions for each firm with the following steps:

1. Firm A’s total revenue equals price times quantity, so

TRA =PA x qA = (400-4PA+2PB)PA= 400PA-4P2A+2PAPB

2. Taking the derivative of firm A’s total revenue with respect to the price it charges yields
𝑑𝑇𝑅𝐴
= 400-8PA +2PB
𝑑𝑃𝐴

3. Setting the equation in Step 2 equal to zero and solving it for PA generates firm A’s reaction
function.
Setting the derivative of total revenue equal to zero maximizes total revenue, which also
maximizes profit given marginal cost equals zero.
𝑑𝑇𝑅𝐴
= 400 – 8PA + 2PB =0 or 400= 2PB + 8PA
𝑑𝑃𝐴
PA =50 + 0.5PB (Firm A’s reaction function)
4. Repeat these steps for firm B to derive its reaction function

TRA = PB x qB = (240-3PB+ 1.5PA) PB =240PB – 3P2B +1.5PAPB

𝑑𝑇𝑅𝐵
= 240- 6PB +1.5PA
𝑑𝑃𝐵
𝑑𝑇𝑅𝐵
= 240-6PB +1.5 PA=0 or 240 + 1.5PA + 6PB
𝑑𝑃𝐵

PB = 40+0.25PA (Firm A’s reaction function)

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5. Substitute firm B’s reaction function into firm A’s reaction to determine PA.
PA = 50+ 0.25PB = 50 + 0.25 (40+0.25PA) = 50 + 10 + 0.0625PA

PA = 60+ 0.0625PA or 0.9375PA = 60 PA = 64

6. Substitute PA equals 64 in firm B’s reaction function to determine PB.

PB = 40 + 0.25PA = 40 + 0.25(64) = 56

The Bertrand duopoly model indicates that firm A maximizes profit by charging $64, and firm B
maximizes profit by charging $56. Note that both the horizontal and vertical axes on the illustration
measure price and not quantity (as in the Cournot and Stackleberg’s models).

Note: In the Bertrand model, firms compete with price. Therefore, reaction functions are expressed
in terms of price, not quantities.

We can conclude this section by commenting that a change in strategic variable firm quantity to
price, a drastic change is evident in the market outcomes.

3.1.4 Stackelberg Oligopoly Model

 Developed by Heinrich F. von Stackelberg (1934): “Market Structure and Equilibrium”

 Competition on quantity
 One firm makes quantity choice before the other firm in the market
 Leader-follower interaction: Stackelberg is the pioneer to introduce

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 The firm that makes a decision first is called Stackelberg leader or quantity leader. The one that
follows is called Stackelberg follower or quantity follower

Example
Consider that the inverse demand function is given by P = 100 – Q, where Q = Q1 + Q2. The
costs of production are given by the cost function: C(Q) = 10Q.

*Firm One starts by solving for Firm Two’s reaction function:

max π2 = TR2 – TC2
max π2 = P(Q)Q2 – C(Q2) [price depends on total output Q = Q1 + Q2]
max π2 = [100 – Q]Q2 – 10Q2
max π2 = [100 – Q1 – Q2]Q2 – 10Q2

max π2 = 100Q2 – Q1Q2 – Q22 – 10Q2

∂π2/∂Q2= 100 – Q1 – 2Q2 – 10 = 0
2Q2 = 90 – Q1

Q2* = 45 – 0.5Q1
Next, Firm One, the leader, maximizes profits holding the follower’s output constant
using the reaction function:

max π1 = TR1 – TC1

max π1 = P(Q)Q1 – C(Q1) [price depends on total output Q = Q1 + Q2]
max π1 = [100 – Q]Q1 – 10Q1
max π1 = [100 – Q1 – Q2]Q1 – 10Q1
max π1 = [100 – Q1 – (45 – 0.5Q1)]Q1 – 10Q1 [substitution of One’s reaction function]
max π1 = [100 – Q1 – 45 + 0.5Q1]Q1 – 10Q1
max π1 = [55 – 0.5Q1]Q1 – 10Q1

max π1 = 55Q1 – 0.5Q12 – 10Q1

∂π1/∂Q1= 55 – Q1 – 10 = 0

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 Q1* = 45

This can be substituted back into Firm Two’s reaction function to solve for Q2*.

Q2* = 45 – 0.5Q1 = 45 – 0.5(45) = 45 – 22.5 = 22.5

Q = Q1 + Q2 = 45 + 22.5 = 67.5
P = 100 – Q = 100 – 67.5 = 32.5
π1 = (32.5 – 10)45 = 22.5(45) = Birr1012.5
π2 = (22.5 – 10)22.5 = 12.5(22.5) = Birr506.25

We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg. These
three models are alternative representations of oligopolistic behavior. The Bertand model is
relatively easy to identify in the real world, since it results in a price war and competitive prices.

 It may be more difficult to identify which of the quantity models to use to analyze a real-
world industry: Cournot or Stackelberg? The model that is most appropriate depends
on the industry under investigation.

1) The Cournot model may be most appropriate for an industry with similar firms, with no market
advantages or leadership.

2) The Stackelberg model may be most appropriate for an industry dominated by

relatively large firms.

To summarize our discussion thus far, we have two models that assume that a firm holds the
other firm’s output constant: Cournot and Stackelberg. These two models result in positive
economic profits, at a level between perfect competition and monopoly. The third model,
Bertrand, assumes that each firm holds the other firm’s price constant. The Bertrand model results
in zero economic profits, as the price is bid down to the competitive level, P = MC.

3.2. Collusive Oligopoly

3.2.1 Cartel

A cartel is a formal organization of oligopoly firms in an industry aiming at centralizing certain

managerial decisions and functions of individual firms with a view to promoting common benefits
ranging from reducing competition and oligopolistic uncertainty to forming barriers to the entry of
new firms. The two important services that a Cartel renders to its members are fixing prices and
market sharing. There are two typical forms of cartels:

A) Cartel aiming at joint profit maximization

This type of cartel arrangement results from the desire to reduce uncertainty arising from mutual
interdependence among the firms. Therefore, the firms seek to maximize joint (industry) profit.

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Consider two oligopolies producing a homogeneous product. If they form a cartel aiming at joint
profit maximization, then they will set a central agency with the authority to decide on the industry
level of output, a price to be charged, and the allocation of production and profit among the firms.
The central agency will collect information about individual costs to derive the market supply curve
by horizontally summing marginal costs of participating firms. It is also assumed that the central
agency will be able to calculate the market demand and the corresponding marginal revenue curves.
The agency then equates industry marginal cost (which is the market supply curve) with marginal
revenue and determines the joint profit maximizing levels of price and output. In the following
diagram the cartel marginal cost curve is obtained by horizontally summing individual marginal
cost curves.

Given the market demand DD, the Cartel (monopoly) solution, which maximizes joint profit, is
determined by the intersection MC and MR at point E where
Total output is Qe=Q1 + Q2
Price = Pe

In order to allocate production, the central agency requires each firm to take the joint profit
maximizing level of MR for use in its output setting rule:
MR* = MC1 for firm one and
MR* = MC2 for firm two
Therefore, firm-A should produce QA and firm-B should produce QB units of the total output i.e. QA
+ QB = Q. The above arrangement helps to maximize the joint profit of the firms. The firm with the
lower cost will produce a larger amount of output but the distribution of profit will be decided by
the central agency alone.

Firm A Firm B
MCA MCB Price
P c P f Pe
a b d e
MC
Ea Eb E

O QA O QB O Qe Quantity

Fig. Price and output determination under Cartel aiming at joint profit maximization

The joint industry profit is the sum total of the areas abcP and defP. The second firm produces QB
units which is greater than QA simply because it has lower costs. The above discussion doesn't imply
that each firm will earn profit to the extent of the shaded region. Rather, profit is shared among the
firms through some arrangement under the agency.

Numerical Approach

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Consider two oligopolies producing X1 and X2 units of a homogeneous product with cost conditions
respectively given by C1(X1) and C2(X2). If both firms form a cartel and seek to maximize joint
profit  where
 =  1 +  2, the task can be formulated as
Maximize: = 1+ 2 
Given P= f(x) = f (x1+x2)
C1= f1(x1)
C2=f2 (x2)

Solution:
 =  1 + 2
= R1-C1+R2-C2
= R1+R2-C1-C2
= PX1+PX2-C1(X1)-C2(X2)
= P(X1+X2)-C1(X1)-C2(X2)
=TR-C1(X1)-C2(X2), Where [ X1 + X2 = X ] and [TR=PX]

The first order conditions (FOC) for profit maximization are:

I)  =  TR .  X1 -  C1 -  C2 = 0 ; Where  X1 = 1 and  C2 = 0
 X1  X1  X1  X1  X1  X1  X1
= MR – MC1 =O

MR = MC1

II)   =  TR .  X2 -  C1 -  C2 = 0; Where  X2 = 1 and  C1 = 0

 X2  X2  X2  X2  X2  X12  X2

= MR –MC2 = 0
MR = MC2
Therefore, in order to maximize joint profit the Cartel should allocate production across the firms
in such a way that:

MR = MC1 = MC2

Second order condition (SOC) for profit maximization is:

 2  =  TR -  2C1 < 0
 X12  X12  X12

 2  =  2TR -  2C2 < 0

 X22  X22  X22
Example: Assume that market demand is P = 100 – 0.5X and that the firms have costs given by C1
= 5X1 and C2 = 0.5X22. The central agency maximizes profit

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 =  1+  2 by allocating output in such a way that MR = MC1 = MC2
P = 100 – 0.5X
TR = PX = (100 – 0.5X)X
TR = PX = 100X – ½ X2
MR = 100 – X
= 100 – X1 – X2
MC1 = 5
MC2 = X2
At equilibrium: MR = MC1
100 – X1 – X2 = 5
95 – X1 – X2 = 0 …….I)
MR = MC2
100 – X1 – X2 = X2
100 – X1 – 2X2 = 0 ….II)
-2(95 – X1 – X2 = 0)
(+) 100 – X1 – 2X2 = 0
-90 + X1 = 0
X1 = 90
X2 = 5
P = 100 – ½ (95)
= 52.5
3.2.2 Price Leadership

Price leadership is a form of collusion in which one firm (the leader) sets price and the others (the
followers) follow it. The follower firms are price takers even when the price set by the leader does
not help them to maximize their independent profits. They follow the leader basically because they
want to avoid uncertainties and price wars in exchange for some losses of profits.

There are three types of Price Leadership. These are:

A. The low cost price Leader ship
B. The dominant firm price Leader ship
C. The barometric price Leader ship

A) The low cost price leader ship:

It is true that one among the group has (may have) a cost advantage over the others. In this case, the
low cost firm sets its profit maximizing level of output by equating its marginal revenue with
marginal cost and the rest of the firms will comply by behaving as price takers.

There are two cases of low cost price leadership.

Case 1 – if both firms share the market equally as shown in the figure below, both firms will face
the same demand curve and their marginal revenue will also be the same. But firm-A is the low cost
firm and will have the discretion to lead the group. Thus, it does by maximizing its own profit in
such a way that MCA = MR. Therefore, at equilibrium P will be charged by firm –A and firm – B
will adopt P as its selling price. But one can see that firm –B is not maximizing profit at price P, as
because its marginal revenue is less than marginal cost. In order to maximize  , therefore, it has to
reduce its supply to QBe and charge PB instead of P.

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 Price
MCB
PBe
Pe MCA

MR d
0 QBeQA=QB Output
Fig. Price and output determination by a low cost price leadership with equal market share

Numerical Example: Given P=105 – 2.5X

C1 = 5X1
C2 = 15X2
Assume that the low cost firm is the leader, it sets price at MR= MC1 by assuming that the other
firm will follow the same price and output.
Assume that X1 = X2
P = 105 – 2.5 (X1 + X2)
P = 105 – 5X1 if X1 = X2
TR1=PX1= (105 – 5X1)X1
TR1=PX1= 105X1– 5X12
MR1 = 105 – 10X1 and MC1= 5
MR1 = MC1
105 – 10X1= 5
X1 = 10 and X2 = 10
P = 55 P = 55
TR1 = 550 TR2 = 550
TC = 50 TC = 150
 1 = 500  2 = 400
But the profit maximizing price and output for the second firm is:
P = 105 – 5X2
TR2=PX2= (105 – 5X2) X2
TR2 =105X2 -5X22
MR2 = 105 – 10X2 and MC= 15
MR2 = MC
105 – 10X2 = 15
X2 = 9
P = 60
TR = 540
TC = 135
 2 = 405 this means, the second firm lost $5.
Case-2: If one firm has relatively a higher market share than the other as shown in the figure below,
the equilibrium levels of output differ while price is maintained at that level chosen by the leader.
In the diagram, firm-A maximizes profit by setting price at Pe such that MCA = MRA. Firm-B will

16
adopt Pe and follows the leader by producing QB. In this case, firm-B is not able to maximize its
profit

MCB
PBe
Pe
MCA

MRB MRA DB DA
0 QBeQBQA output
Fig. Price and output determination under the low cost price leader ship with different
market share

B) The dominant firm price leadership

In this case, it is assumed that sone firm among the group is very large and is in a position to calculate
its demand curve as a residual to the market demand after the rest of the firms have supplied their
share of the market. The dominant firm knows the marginal cost figures of the other firms in the
group and calculates their total market supply. Next, it arrives at its market share at each price level
by deducting total supply by all the firms excepting its (S1) from the total market demand (D) as is
illustrated in the figure bellow.

Price Panel-A Panel-B

S1
P1 MC
P Pe
P2 DL

D MRL

0 Sf Sd Q 0 QL

Fig. Price and output determination by a dominant firm price leader ship
In panel-A, D is the market demand that all firms including the dominant firm face and S1 is the
supply schedule for all small firms. In panel- B, the dominant firm calculates its average revenue
curve in such a way that, at each price level it deducts S1 from D (its quantity demanded is the excess
of D over S1).

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At P1 market quantity demanded is exactly the same as quantity supplied by the non-dominant firms
hence when price is P1 the leader supplies none. At P2 all the non-dominant firms are not willing to
supply. Therefore, S1 = 0 and the whole of the market is supplied by the leader.

With its demand curve calculated in the above manner, the firm equates its MR with MC to
determine the profit maximizing level of price, which is Pe (panel-B). The rest of the firms will
adopt Pe whether it is consistent with their motive to independently maximize profit or not.

Both in the low cost and dominant firm models of price leadership, the leader firm will be able to
maximize profit only if it is able to enforce the followers to produce the respective output levels
through some tight sharing the market arrangement. Otherwise the non – leader firms may reduce
the output level even though they stick to the leader – set – level of price. In the latter case the profit
– maximizing price of the leader may not be stable.

Numerical Example: given

D= 50 – 0.3P market demand function
S = 0.2P SS curve of small firms and
C = 4X cost function of dominant firm
Find the price set by the dominant firm and the output of dominant firm and other firms?

Solution D= 50 – 0.3P
X=50 – 0.3P – 0.2P supply function of dominant firm.
X=50-0.5p
P= 100-2X
TR=PX = (100-2X) X
TR=PX = 100X – 2X2
MR = 100 – 4X and MC= 4
MR = MC
100 – 4X= 4
4X = 96
Xd = 24 Sf = 10.4
P = 52 D = 34.4

C) Barometric Price Leadership

Here the price leader is not necessarily the dominant or the low cost firm. It is the barometric firm
which has a better knowledge of prevailing market conditions and an ability to predict the market
conditions more precisely than any of its competitors. Here, barometric firm implies a firm having
a good state of mind to better understand the structure of the market that prevails in the current state
of conditions experienced by firms.

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