Managerial Economics and Strategy

Third Edition

Chapter 11

Oligopoly and Monopolistic

Competition

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Learning Objectives (1 of 2)
11.1 Cartels
Describe how firms in a cartel raise their profits by
coordinating their actions
11.2 Cournot Oligopoly
Model how firms independently choose their output levels
to determine the Nash-Cournot equilibrium

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Learning Objectives (2 of 2)
11.3 Bertrand Oligopoly
Show how firms independently choose their prices to
determine the Nash-Bertrand equilibrium
11.4 Monopolistic Competition
Explain how two conditions determine the monopolistic
competition equilibrium

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11.1 Cartels (1 of 5)
Why Cartels Succeed or Fail
• Oligopolistic firms have an incentive to form cartels in which they
collude in setting prices or quantities so as to increase their profits.
– The Organization of Petroleum Exporting Countries (OPEC) is
a well-known example of an international cartel.
• Typically, each member of a cartel agrees to reduce its output from
the level it would produce if it acted independently. As a result, the
market price rises, and the firms earn higher profits.
• If the firms reduce market output to the monopoly level, they
achieve the highest possible collective profit.
• However, each member has an incentive to cheat.

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11.1 Cartels (2 of 5)
Why Cartels Form

• A cartel forms if members of the cartel believe that they can raise their profits by
coordinating their actions.
– A cartel takes into account how changes in any one firm’s output affect the profits
of all members of the cartel.
– Therefore, the aggregate profit of a cartel can exceed the combined profits of the
same firms acting independently.

• Competitive market versus cartel:

– In Figure 11.1, there are n competitive firms, and no further entry is possible.
– In panel b, at the point of competitive equilibrium, the market output is Qc = nqc
and price is pc. In panel a, each firm takes pc and produces qc  Qc / n.
– If the n firms form a cartel and act like a monopoly, the market output reduces to Q
m but the price goes up to pm in panel b. The cartel profit increases, and individual
profits go up if firms charge pm and reduce output to qm in panel a.

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Figure 11.1 Comparing Competition
with a Cartel

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11.1 Cartels (3 of 5)
Why Cartels Fail
• External reasons:
– Cartels are generally illegal in developed countries. High fines and jail
terms may prevent collusion.
– Some cartels fail because they do not control enough of the market to
significantly raise the price.
• Internal reasons:
– Cartel members have incentives to cheat if a member thinks its firm is just
one of many firms so its extra output hardly affects the market price and
the other firms in the cartel can’t tell who is producing more.
– In panel a of Figure 11.1, each firm agreed to qm. However, a price taker
firm maximizes profit selling q*, where pm= MC. It makes extra money by
producing more than qm, as long as MR > MC.
– As more and more firms cheat, pm falls. Eventually, the cartel collapses.

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11.1 Cartels (4 of 5)
Maintaining Cartels
• To keep firms from violating a cartel agreement, the cartel must detect
cheating and punish violators.

Detection and Enforcement

• Cartels use different techniques to detect cheating.
– Some cartels may give members the right to inspect each other’s
accounts or divide the market by region or by customers.
– Cartels may turn to industry organizations to collect data on a firm’s
market share.
• Cartels use various methods to enforce their agreements.
– Most-favored-customer clause: The seller would not offer a lower
price to any other current or future buyer without offering the same price
decrease to the firms that signed these contracts.

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11.1 Cartels (5 of 5)
Common Confusion:
• Requiring government agencies to report which company had the
lowest bid for a government contract and the level of the bid is good
for the public.
– Although society benefits in many ways from government
transparency, disclosing this type of information can help a cartel
enforce its agreement.
Government Support and Barriers to Entry
• Sometimes governments help create and enforce cartels, exempting
them from antitrust and competition laws.
• With high barriers to entry, cartel members are few. The fewer the
firms in a market, the easier to find cheaters and to impose penalties.

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11.2 Cournot Oligopoly (1 of 8)
The Cournot Model

• Four assumptions: Few firms and no entry, identical costs and identical products,
firms set their quantities independently and simultaneously.

• Strategic choices: Firms set quantities. So, the price adjusts as needed until the
market clears. Profits are interdependent.

• Firms use their residual demand curves: Market demand that is not met
by other sellers at any given price, D r ( p )  D( p )  Q o . Figure 11.2, panel b, shows
the residual demand curve for American if qU  64.

• A firm maximizes profit with best responses that come from MR r  MC.
In Figure 11.2, panel b, if American believes qU=64, then its best response is qA=64.

• Nash-Cournot equilibrium: A set of quantities chosen by firms such that, holding the
quantities of all other firms constant, no firm can obtain a higher profit by choosing a
different quantity.
– The quantity of equilibrium must be on the best-response curve for all firms.

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Illustrative Example:
Assume that United and American Airlines are facing the Market
Demand schedule of Q = 339 – P with MC = $147. What is the
quantity of tickets sold by both and the price they charge in the
Cournot Oligopoly framework?

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Figure 11.2 American Airlines’ Profit-
Maximizing Output

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11.2 Cournot Oligopoly (2 of 8)
Airlines

• American and United Airlines compete for customers on flights between Chicago and
Los Angeles (duopoly). Q = qA + qU
A Graphical Approach

• The strategies for American and United depend on their residual demand curves and
marginal costs.

• Residual Demands: If American thinks United flies qU passengers, American’s

residual demand is qA  Q( p )  qU (Figure 11.2, panel b). Alternatively, United’s
residual demand is qU  Q( p )  q A.
• Best Responses: To maximize profit, American sets MR r  MC and finds its best-response
curve for all possible qU. Figure 11.3 shows that if qU = 64, American’s best response is q
A = 64, shuts down if qU = 192, and so on. It also shows United’s best-response curve.

• Nash-Cournot Equilibrium: There is only one pair of outputs where both firms are on their
best-response curves, qA = qU = 64. At this intersection, both firms maximize profits, are
on their best-response curves, and don’t want to change their outputs.
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Figure 11.3 Best-Response Curves for
American and United Airlines

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11.2 Cournot Oligopoly (3 of 8)
An Algebraic Approach

• Residual Demand, MR and MC

– The market demand function is Q = 339 − p. The residual demand function for
American is qA = (339 − p) − qU or p = 339 − qA − qU.
– American’s marginal revenue function is MR r  339  2qA  qU .
– Both airlines have MC = AC = $147 per passenger per flight.

• MR = MC and Best Responses

– MR r  MC, so 339  2qA  qU  147
– American’s best-response: qA = 96 − 0.5 qU
– Similarly, United’s best response: qU = 96 − 0.5 qA

• Nash-Cournot Equilibrium
– Solving the two best responses by substitution, qA = 96 − 0.5 (96 − 0.5 qA)
– The Nash-Cournot equilibrium values: qA = qU = 64, Q = qA + qU = 128, p=$211

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11.2 Cournot Oligopoly (4 of 8)
Airlines Cournot Model Using Calculus
• Inverse residual Demand, MR and MC
– The market demand function is Q = 339 − p.
– The residual demand function for American is qA = (339 − p) − qU.
– Inverse residual demand is p = 339 − qA − qU.
– American’s revenue function: RA  pq A  (339  q A  qU )qA  339qA  q 2 A  qU qA
– American’s marginal revenue function: MR r  dRA / dq A  339  2qA  qU
– United’s revenue function: RU  339qU  q 2U  qU q A
– United’s marginal revenue function: MR  dRU / dqU  339  2qU  q A
r

• Best Responses and Nash-Cournot Equilibrium

– Same steps and calculations as presented in the algebraic approach

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11.2 Cournot Oligopoly (5 of 8)
The Number of Firms
• If two Cournot firms set output independently, the price to consumers is
lower than the monopoly price. If there are more than two, the price is
even lower.
• Table 11.1 illustrates how each firm’s output, q, the market quantity, Q,
and the price vary with the number of firms in our airlines example.
– If n = 1, Q = 96, p = $243, a monopoly outcome.
– If n = 2, Q = 128, p = $211, a duopoly outcome as we found earlier.
– If n is very large, Q = 192 and p = $147 = MC.
– With 100 firms, the price is only 1.3% above the competitive price
and output is only 1.1% below the competitive quantity.
– The Nash-Cournot equilibrium approaches the competitive
outcome.
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Table 11.1 Nash Cournot Equilibrium
Varies with the Number of Firms
Number of Firm Output, Market Output, Firm Profit, π ($
Firms, n q Q Price, p thousands)
1 (monopoly) 96 96 243 9,216
2 (duopoly) 64 128 211 4,096
3 48 144 195 2,304
4 38 154 185 1,475
5 32 160 179 1,024
10 18 175 164 305
50 4 188 151 14
100 (nearly 2 190 149 4
competitive)

Note: The numbers in this table are rounded.

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11.2 Cournot Oligopoly (6 of 8)
Nonidentical Firms

• Oligopoly firms can have different costs and differentiate their products.

Unequal Costs
• In the Cournot model, a firm’s best-response function comes from MR = MC. If MC
rises or falls, then the firm’s best-response function shifts.
• Consider the airline example, products are identical, so American and United charge
the same price. United’s MC drops from $147 to $99, so in Figure 11.4, panel a, the
new qU = 88 rather than 64.
• United’s best-response function shifts to the right in panel b of Figure 11.4. United
wants to produce more than before for any given level of American’s output.
• There is no change for American’s best-response function.
• In panel b of Figure 11.4, the Nash-Cournot equilibrium shifts from e1 to e2, at which
United sells 96 and American sells 48.
• United’s profit increases from $4.1 million to $9.2 million, while American’s profit falls
to $2.3 million. Consumers also win because p falls from $211 to $195.
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Figure 11.4 Effect of a Drop in One Firm’s
Marginal Cost on a Nash-Cournot Equilibrium

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11.2 Cournot Oligopoly (7 of 8)
Differentiated Products
• By differentiating its product from those of a rival, an oligopolistic firm can shift
its demand curve to the right and make it less elastic.
• The less elastic the demand curve, the more the firm can charge because
consumers are willing to pay more for a product that “seems” superior.
• Although differentiation leads to higher prices, which harm consumers,
differentiation is desirable in its own right.
– Consumers value having a choice, and some may greatly prefer a new
brand to existing ones.
• If consumers think products differ, the Cournot quantities and prices may differ
across firms.
– Each firm faces a different inverse demand function and hence charges a
different price.

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11.2 Cournot Oligopoly (8 of 8)
Mergers
• Two or more firms combine their assets and operations into one firm with the
objective to increase profits.
• Firms typically merge to reduce costs or to increase market power.
– A merger may provide cost advantages by allowing the new firm to realize
increased economies of scale (Chapter 6).
– A merger may produce economies of scope (Chapter 6).
– A vertical merge between a firm and a supplier may lower cost by allowing
for a more efficient supply chain.
– Horizontal mergers may increase market power and reduce competition.
– If such mergers increase market power, raising prices harms consumers
and reduces total welfare.
– Most countries have antitrust or competition laws that subject mergers and
acquisitions to legal scrutiny (Chapter 16).

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11.3 Bertrand Oligopoly (1 of 6)
The Bertrand Model

• Model rationality
– Bertrand oligopoly firms set prices and then consumers decide how many units to buy.

• Logic of best responses

– In a duopoly setting, Firm 1’s best-response curve comes from answering “What is
Firm 1’s best response—what price should it set—if Firm 2 sets a price of p2 = x?” for
all possible values of x.
– Similarly, Firm 2’s best-response curve: “What is Firm 2’s best response (p2) if Firm 1
sets a price of p1 = y?” for all possible values of y.

• Nash-Bertrand equilibrium
– The Nash-Bertrand equilibrium is a set of prices such that no firm can obtain a higher
profit by choosing a different price if the other firms continue to charge these prices.
– The Nash-Bertrand equilibrium differs from the Nash-Cournot equilibrium; it depends
on whether firms produce identical or differentiated products.

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11.3 Bertrand Oligopoly (2 of 6)
Identical Products

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11.3 Bertrand Oligopoly (3 of 6)
Identical Products
• Let us focus in a price-setting oligopoly where firms have identical costs and
produce identical products.
Best-Response Curves and Nash-Bertrand Equilibrium
• Two firms with identical costs and identical products, MC = AC = $5.

• In Figure 11.5, Firm 1’s best-response curve starts at $5 and then lies
slightly above the 45° line. That is, Firm 1 undercuts its rival’s price as long as
its price remains above $5.
• Firm 2’s best-response curve also starts at $5 and undercuts its rival’s price
if p2 > 5.

• Nash-Bertrand Equilibrium at intersection point e, p2 = p1 = $5 = MC.

• The Nash-Bertrand equilibrium when firms produce identical products is

the same equilibrium as perfect competition equilibrium.
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Figure 11.5 Nash-Bertrand Equilibrium
with Identical Products

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11.3 Bertrand Oligopoly (4 of 6)
Bertrand versus Cournot with Identical Products
• The Nash-Bertrand equilibrium differs substantially from the Nash-Cournot
equilibrium. Zero profits (p = MC) versus positive profits (p > MC).
• The Cournot model seems more realistic than the Bertrand model in two ways:

• Bertrand’s “Competitive” Equilibrium is Implausible.

– In a market with few firms, why would the firms compete so vigorously that
they would make no profit?
– Oligopolies typically charge a higher price than competitive firms. So, the
Nash-Cournot equilibrium is more plausible.
• Bertrand’s Equilibrium Price is insensitive to demand conditions and the number
of firms. It depends only on costs.
– The Nash-Cournot equilibrium price is sensitive to demand conditions and
the number of firms as well as on cost. So, it is better to study
homogeneous goods markets.
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11.3 Bertrand Oligopoly (5 of 6)
Differentiated Products

• Two firms, identical costs MC = AC = $5 and differentiated products

Best-Response Curves and Nash-Bertrand Equilibrium

• In Figure 11.6, neither firm’s best-response curve lies along a 45° line through the
origin because Coke and Pepsi are similar, but some consumers prefer one to the other
independently of the price. So neither firm has to exactly match a price cut by its rival.

• Nash-Bertrand Equilibrium at intersection point e, p2 = p1 = $13 > MC. Each firm sets
its best-response price given the price the other firm is charging. Neither firm wants
to change its price.
– This equilibrium is plausible: Firms set p > MC, and prices are sensitive to
demand conditions and number of firms.

• Bertrand firms may earn positive profits in equilibrium if they differentiate their products.
– Product differentiation is costly. But, if the alternative is zero profit in a Bertrand
homogenous-good equilibrium, it is worth the cost.

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Figure 11.6 Nash-Bertrand Equilibrium
with Differentiated Products

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11.3 Bertrand Oligopoly (6 of 6)
Managerial Implication: Differentiating a Product Through Marketing
• A manager can often increase a firm’s profit by differentiating its product so that
it can charge a higher price.
• It is easier and less expensive to differentiate a product using marketing rather
than by physically differentiating the product. For instance, Coca-Cola and
Pepsico differentiate their uncarbonated, unflavor water with marketing.
– Both, Pepsico’s top-selling bottled water, Aquafina, and Coke’s Dasani
have logos from which consumers may infer the water comes from natural
springs. However, both are basically bottled public water.
– In a recent blind taste test reported in Slate, no one could distinguish
between Aquafina and Dasani, and both are equally clean and safe.
However, many consumers, responding to perceived differences created by
marketing, strongly prefer one or the other of these brands and pay a
premium for these products.

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 Price Competition with Differentiated Products
 
Suppose each of two duopolists has fixed costs of $20 but zero variable costs, and that they face
the same demand curves:
Firm 1’s demand: 12 - 2 +
Firm 2’s demand: 12 - 2 +
Firm 1’s revenue: 12 - 2 + - 2
Firm 1’s marginal revenue: MR = + , setting MR = MC = 0
Firm 1’s reaction curve: 3 +
With similar computations;
Firm 2’s reaction curve: 3 +
Substituting into Firm 1’s reaction curve: 3 +
, => = $4 => =3 +
How about profits? = 8
8

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12.4 Competition versus Collusion:
The Prisoners’ Dilemma
In our example, there are two firms, each of which has fixed costs of $20 and zero variable costs. They
face the same demand curves:
Firm 1’s demand:
Firm 2’s demand:
We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of $12, whereas if
the firms collude, they will charge a price of $6 and earn a profit of $16.
But, if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase to $20. And it will do so
at the expense of Firm 1’s profit, which will fall to $4.

● noncooperative game Game in which PAYOFF MATRIX FOR PRICING GAME

negotiation and enforcement of binding FIRM 2
contracts are not possible.
CHARGE $4 CHARGE $6

● payoff matrix Table showing profit (or

payoff) to each firm given its decision and Charge $4 $12, $12 $20, $4
the decision of its competitor. Firm 1
Charge $6 $4, $20 $16, $16

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THE PRISONERS’ DILEMMA

● Prisoners’ Dilemma Game theory example in which two prisoners must decide separately whether
to confess to a crime; if a prisoner confesses, he will receive a lighter sentence and his accomplice will
receive a heavier one, but if neither confesses, sentences will be lighter than if both confess.

TABLE 12.4 PAYOFF MATRIX FOR PRISONERS’ DILEMMA

PRISONER B
CONFESS DON’T CONFESS

Confess –5, –5 –1, –10

Prisoner A
Don’t confess –10, –1 –2, –2

If Prisoner A does not confess, he risks being taken advantage of by his former accomplice. After all, no
matter what Prisoner A does, Prisoner B comes out ahead by confessing. Likewise, Prisoner A always
comes out ahead by confessing, so Prisoner B must worry that by not confessing, she will be taken
advantage of. Therefore, both prisoners will probably confess and go to jail for five years. Oligopolistic
firms often find themselves in a prisoners’ dilemma.

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3
11.4 Monopolistic Competition (1 of 4)
• The monopolistic competition market structure has the price-setting characteristics of
monopoly or oligopoly and the free entry of perfect competition.
– These firms face downward sloping demand curves and have oligopoly market
power.
– But they earn zero profit due to free entry.

• First Reason for Downward-Sloping Demand

– Market demand may be limited so there is room for only few firms. The residual
demand curve facing a single firm is downward sloping.
– For example in a small town, the market may be large enough to support only a
few plumbing firms, each provides a similar service.

• Second Reason for Downward-Sloping Demand

– Firms differentiate their products. So each firm can retain those customers who
particularly like that firm’s product even if its price is higher than those of rivals.
– For example, gourmet food trucks serve differentiated food in monopolistically
competitive markets.

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11.4 Monopolistic Competition (2 of 4)
Managerial Implication: Managing in the Monopolistically Competitive
Food Truck Market
• Young entrepreneurs should consider monopolistically competitive markets,
as entry costs are often low and a cleverly differentiated product can often
succeed.
• One of the hottest food phenomena in the United States is gourmet food
trucks.
– The cost of entry is very low, from $50k to lease the equipment and pay
ancillary expenses, to $250k or more for a deluxe truck.
– Potential entrants can go to mobilefoodnews.com to learn about local
laws, where to buy equipment and obtain insurance.
– Managers could use internet sites and social media to attract customers
to their locations. Fans can find the location of trucks in cities around the
country at Mobimunch.com.

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11.4 Monopolistic Competition (3 of 4)
Equilibrium
• Firms have identical cost functions and produce identical products.
• In Figure 11.7, a monopolistically competitive firm, facing the firm-specific
demand curve D, sets its output where MR = MC.
• At that quantity, the firm’s average cost curve, AC, is tangent to its demand
curve, p = AC.
• At the equilibrium, the monopolistically competitive firm makes zero profit.
The entry and exit responses of firms ensure this.
• In most cities, fast-food restaurants are an example of a monopolistically
competitive industry.
– These restaurants differentiate their food, so each may face a
downward-sloping demand curve. However, restaurants can easily
enter and exit the market, so the marginal firm earns zero economic
profit.

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Figure 11.7 Monopolistic Competition

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11.4 Monopolistic Competition (4 of 4)
Profitable Monopolistically Competitive Firms
• Identical Costs and Products, Zero Profit
– If all firms in a monopolistically competitive market produce
identical products and have identical costs, each firm earns zero
economic profit in the long run.
– Thus, all firms in the industry are on the margin of exiting the
market because even a slight decline in profitability would
generate losses.
• Differentiated Costs and Products, Positive Profit
– If those firms have different cost functions or produce
differentiated products: most likely firms differ from each other in
their profitability.
– If so, low-cost firms or firms with superior products may earn
positive economic profits in the long run.
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Managerial Problem
Gaining an Edge from Government Aircraft Subsidies
• Airbus and Boeing are the only manufacturers of large commercial planes.
• If only one firm receives a subsidy, how can it gain competitive advantage? What is the
subsidy’s effect on p and q? What happens if both governments subsidize their firms? Is
a subsidy war good for both firms?
Solution Approach
• We need to focus on two markets. An oligopolistic market has few sellers and barriers
to entry, firms have market power and may or may not collude to form cartels. A
monopolistic competitive market has firms with market power, but there is free entry
in the long run.
Empirical Methods
• Within a cartel, oligopoly firms collude to raise price and profits.
• Oligopoly firms can independently set quantities (Cournot Model) or prices (Bertrand
Model).
• In monopolistic competitive markets, firms charge prices above marginal cost but
make no economic profit in the long run.

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Managerial Solution
Gaining an Edge from Government Aircraft Subsidies
• If only one firm receives a subsidy, how can it gain competitive advantage? What is the
subsidy’s effect on p and q? What happens if both governments subsidize their firms? Is a
subsidy war good for both firms?
Solution
• Assume Airbus and Boeing compete in a Cournot model, produce identical products
with identical costs and face a linear demand curve.
• A government per-unit subsidy to one firm would make its MC lower than its rival’s
and its best-response curve shifts out.
• If only Airbus is subsidized, Airbus should produce more given any expected q from
Boeing. Airbus’ q and π rise while Boeing’s q and π fall.
• If both governments give identical subsidies, both firms produce more, total Q
increases, p falls (both move to competitive equilibrium) and both π fall. Each
government is subsidizing final consumers in other countries without giving its own
firm a competitive advantage. A subsidy war is not in these countries’ best interests.
• These firms should not stop lobbying for subsidies to avoid being at a competitive
disadvantage if its rival received a subsidy and it did not.

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