Chapter Five: Market Structure 5.1 Perfectly Competition Market Structure

CHAPTER FIVE
Market Structure
5.1 Perfectly Competition Market Structure
The structure of the market is a description of the behavior of buyers and sellers in that
market. Market structure is broadly grouped into two: perfectly competitive market and
an imperfectly competitive market. A competitive market is one in which buyers and
sellers assume that their own buying and selling decisions have no effect on market price.
An imperfectly competitive market is a market where either buyers or sellers take into
account the effects of their own actions on market price. This market includes monopoly,
monopolistic competition, and oligopoly (in the case of output market); or monopsony,
monopsonistic competition and ologopsony (the case of factor market). In this chapter we
consider the first one (i.e. perfectly competitive market).
5.1.1 Perfectly Competition is a market structure in which there is a complete absence of

direct competition among economic agents; i.e. absence of rivalry among individual
firms. A market is said to be perfectly competitive when all firms regard themselves as
price takers; i.e. they can sell all they wish at the going market price. A set of conditions
that is sufficient to guarantee this perfect competition (sometimes known as (assumptions
of perfect competition) are:
i) Very large number of buyers and sellers in the market; and thus the share of
each firm in the market is very small. That is, it is characterized by large
number of small sized firms.
ii) Product homogeneity. There is no way in which buyers could differentiate
among the product of the different firms.
iii) Because of the above two assumptions, individual firms in pure competition is
P a price-taker; i.e. firm’s demand curve is
perfectly elastic, implying that the firm can sell
any amount of output at the prevailing market
P* d
price, P*.
Q
0
iv) Free entry and exit from the industry (or market).
v) Government intervention into the market is little or nil.
vi) All buyers and sellers have complete knowledge of conditions of the market.
vii) The goal of the firm is profit maximization.
Review of Some Basic Concepts:
1. The Firm’s Demand Curve:

Under perfect competition a firm is a price taker and faces a perfectly elastic demand
curve (see assumption (iii) above). Thus, the graphical presentation of the firm’s demand
curve is horizontal straight line drawn at the going market price. This implies that the
firm can sell any quantity it wishes at the market price P*. If the firm raises its price
Compiled by Dechassa G. and Milkessa D. (Msc in Economics) 2017 Microeconomics (Econ 201) 1
above P* its sales will fall to zero since all the customers realize that they can buy the
same/identical product elsewhere at the price P*. In other words, the demand curve is
perfectly elastic at the going market price P*.
2. The firm’s Average and Marginal Revenue Curve:
A perfectly elastic demand curve has an important characteristic: the average revenue
(AR) from the sale of every unit will be equal to the marginal revenue (MR) from the sale
of an extra unit. AR is another term for the price at which the firm sells its product. It is
given by total revenue divided by the total quantity sold; i.e. AR = R/Q. MR is the change
in total revenue resulting from the sale of an additional unit of the product. That is, MR =
dR/dQ. Since the firm can sell as much or as little as it wants at the going price, MR must
be equal to AR. This can be shown as below:
P AR (or Demand): P = f(Q); & and hence total revenue (R) is the
product of price & quantity sold; that is,
R = P*Q. Therefore:
P* AR=MR
 AR = R/Q = P*Q/Q = P; and
 MR = dR/dQ = d(P*Q)/dQ = P[dQ/dQ] = P. Thus, AR,
Q P and MR are all the same in perfect competition since
0
demand is perfectly elastic (or price is fixed).
3. Firm’s Cost Curve:

The cost structure of a firm any market situation is the same; that is, we will consider a
traditional theory of costs, where all unit costs are U-shaped except the average fixed cost
(which is rectangular hyperbola).
4. Equilibrium of the Firm
A. Short-run Equilibrium of the Firm:

The firm is said to be in equilibrium when it maximizes its profit. There are two
approaches in profit maximization:
(i) Total revenue – Total cost Approach: The firm is in equilibrium (maximizes
profit when the difference between revenue (R) and cost (C) is greatest. The
total revenue curve is a straight line through the origin, showing that price is
constant at all level of outputs (see figure below). The slope of revenue curve
is also called marginal revenue (dR/dQ). It is constant and equal to the
prevailing market price. Note that the firm maximizes its profit at the output
level where the distance between revenue and cost curve is the greatest. To the
left of point ‘a’ and to the right of point ‘b’ there is a loss because total cost
exceeds total revenue.
C/R
C
R
Maximum b
Profit
a
C
Qe Q
Numerical illustration: Consider the following cost schedule of a certain competitive

firm where market price is given at birr 20. Determine the level of output that maximizes
profit and the maximum profit.
MC TR MR Unit  Total 
Q TFC TVC TC dTC/d P*Q dR/dQ P-AC R-TC
Q
0 30 0 30 -- 0 -- 0.00 -30
1 30 10 40 10 20 20 20.0 -20
2 30 15 45 5 40 20 -2.5 -5
3 30 21 51 6 60 20 3.00 9
4 30 29 59 8 80 20 5.25 21
5 30 40 70 11 100 20 6.00 30
6 30 54 84 14 120 20 6.00 36
7 30 74 104 20 140 20 5.43 36
8 30 95 125 23 160 20 4.38 35
9 30 124 154 27 180 20 2.89 26
10 30 160 190 36 200 20 1.00 10
Profit maximizing level of output would be 7 units (not 6 units) because more output is
preferred. Thus, maximum profit equals 36 birr.
(ii) Marginal Approach:

The total revenue-total cost approach can only indicate the level of profit or loss but it
doesn’t help for analytical interpretation of business behavior. So the marginal approach
is used for further analysis. In this case, the firm’s equilibrium occurs at the level of
output defined by the intersection of marginal cost (MC) and marginal revenue (MR)
curves (see point e in figure below).
If MR exceeds MC, profit has to been maximized and it pays the firm to expand its
output. If MR is less than MC, the level of profit will be reduced and hence it pays the
firm to cut its production. Thus, it follows that short-run equilibrium occurs when MC
equals MR. Thus, the first condition for profit maximization is that MC is equal to MR;
and the second (or sufficient) condition for equilibrium requires that MC curve must cut
MR curve from below (i.e. the slope of MC should be greater than the slope of MR).
In short, at equilibrium (maximum profit) the following conditions must be satisfied:
1. MR MC; and
2. MC must be rising (i.e. slope of MC must be greater than slope of MR).
P
R, SMC The fact that a firm is in short-run equilibrium
C, SAC doesn’t necessarily mean that it makes excess
profits. Whether the firm makes excess profits
D e
P* C MR=AR or loses depends on the level of the average
A D B cost at short-run equilibrium. If the average
cost is below the price (or AR) at equilibrium,
Excess  the firm earns excess profit equal to the
shaded are ABeP* in this figure. If AC>P,
there is a loss equal to the shaded region
0 Qe Q AP*Be.
The Supply Curve of the Firm and the Industry:

The supply curve of the firm is usually upward sloping, indicating a direct relationship
between price and quantity supplied. This upward sloping supply curve of the firm could
be derived by the points of intersection of its MC curve with successive demand curves.
As it can be seen in figure below, at price P1 the firm reaches its equilibrium at point e1,
producing and supplying Q1 units. If market price increases to P2 (demand shifts to d2),
and the firm will be in equilibrium at point e 2 producing and supplying Q2 units, and so
on.
P/C
Price
S
MC
AVC
P3 e3
P1
e2
P2 P2
P1 e1 P3
0 Q1 Q2 Q3 0 Q1 Q2 Q3 Q
Q
If the price falls below P1 the firm will not supply any quantity since it doesn’t cover its
variable costs (i.e. the firm will minimize loss by shutting-down the business in which
case it will only pay TFC). Thus, if we plot the successive points of intersection of MC
and demand (or AR) curves, we will obtain the supply curve of an individual firm. It is
identical to the MC curve to the right of (or above) the shut-down point, e1.
Short-run Equilibrium of the Industry:

Even though the individual or firm’s demand curve is perfectly elastic (horizontal, the
industry demand curve is downward-sloping. Therefore, given the market demand curve
and supply curve of the industry, the market is in equilibrium at a price which clears the
market (i.e. the price at which quantity demanded is equal to quantity supplied). See
figure below for industry equilibrium.
P/C P Industry Equlb.

Firm’s equlb.
S
MC
P* d P*
D
0 qe q 0 Qe Q
The firm is in equilibrium producing qe level of output at price P*. And the industry
reaches equilibrium at the same price P* but producing Qe of output.
B. Long-run Equilibrium:
In he long-run since all inputs are variable the firm has the option of adjusting its plant
size as well as output to achieve maximum profit. Similarly, adjustment f the number of
firms in the industry in response to profit motivation is the key element in establishing
long-run equilibrium.
Firm’s Long-run Equilibrium:

In the long-run firms are in equilibrium when they have adjusted their plant so as to
produce at the minimum point of their LAC curve. Thus, in the long-run firms earn just
normal profit (or zero economic profit).
5.2 Imperfect Market Structure
5.2.1. Pure Monopoly
5.2.1. Definition
Monopoly is a market structure in which there is a single seller, there is no close

substitute for the commodity it produces and there are substantial entry barrier.
Monopoly is a Greek word Derived from “Mono”, which means “One” and “Poly”,
which means “Seller”. Therefore, monopoly means one seller. The monopoly firm
produces a unique product, i.e. a product which does not have any close substitutable at
all in the market.
Unlike a perfectly competitive firm, a pure monopoly firm is a Price Maker. That is, the
firm has the power to change the price of its commodity.
In this type of market structure there are substantial entry barrier. That is no firm can
enter into this market.
5.2.2. Source of Monopoly

I. Ownership of strategic raw material:- or exclusive ownership of production
techniques.
Example: Suppose input X is required to produce output Y. If one firm has

exclusive control over input X, then this firm can easily establish a monopoly
over product Y simply by refusing to sell X to any potential competitors.
II. Legal Barriers – includes patents, franchise and government licenses:-
A public Franchise a right granter to a firm by government that permits the firm to
provide a particular good or service and exclude all others from doing the same (thus
eliminating potential competitors by law).
Patents are granted to inventors of a product or process for a certain specific period of
time. For example in Ethiopia, patents are given for a period of 15 years. During this
period, the patent holder is shielded from competitors; no one else can legally produce
and sell the patented produce or process. The rationales behind patent right is to
encourage innovation in an economy.
Entry into some industries and occupations requires a government granted license.
For example, radio and television stations cannot operate without a license from the
Federal Communication Authority.
III. Natural Monopoly: - the size of the market may be such as not to support
more than one plant of optimal size. The technology may exhibit substantial
economies of scale, which require only a single plant if they are to be fully
reaped. An example of natural monopoly includes communications,
electricity, transport, water, etc usually; government undertakes the
production of the commodity or the service so as the avoided exploitation of
the consumer.
IV. Limit- pricing policy: is a pricing policy aiming at the prevention of new
entry. Such a pricing policy may be combined with other policies such as
heavy advertising which render entry unattractive.
5.2.3. Demand and Revenue

Since there is a single firm in the industry, the firms demand curve is the industry
demand curve. The demand curve of a monopolist is downward sloping,
implying that the firm has the power to change the price of its commodity. A
downward – sloping demand curve posits an inverse relationship between price
and quantity demanded. More is sold at lower price than at higher price, cetris
paribus. Unlike the perfectly competitive firm, the monopolist can raise its price
and still sell its product (though not as much)
P
D’
D Q Q
MR
Figure 1.1
Q = a-b*P----------- demand Equation

a. The slope of the demand curve is:
dQ =-b
dp
b. The price elasticity of demand is
Ed = dQ * P
dp Q
Ed = -b * P
Q
a. At point D the elasticity approaches infinity
Ed = -b - P
Q ∞
b. At point D’ the elasticity is zero
Ed = -b * P
Q 0
c. At the mid point C the price elasticity is unity
Ed = -b * P
Q -1
c. Total Revenue of the monopolist
TR= P.Q
Take the inverse demand equation i.e.
Q = a – b*P
Q – a = - b*P
b*P = a – Q
P = a - 1*Q
b b
Lets suppose a = c and 1 = d , thus

b b
P = c-d*Q ------- Demand Curve
TR = P.Q
TR = (c- d*Q)Q
TR = c*Q – d*Q2 -------- Total Revenue Equation
d. The Average Revenue (AR) is the price
AR = TR
Q
AR = c*Q-d*Q2
Q
AR = c – d*Q
AR = P
Thus, the demand curve is also the AR curve
e. The Marginal Revenue
MR = dTR
dQ Where TR = CQ – dQ2
MR = C – 2dQ
That is, the MR is a straight line with the same intercept as the demand curve, but twice
as steep.
f. Relationship between MR and P
TR = PQ
MR = dTR
dQ
MR = d (P*Q)…………… Apply the Product Rule
dQ
MR = P * dQ + Q* dP
dQ dQ
MR = P + Q. dP
dQ
MR = P - Q. dP Since dP <0
dQ dQ
MR + Q*dP = P
dQ
Hence, P > MR by an amount equal to (Q* dP )
dQ
g. The Relationship between MR and Price Elasticity (Ed) is
TR = P*Q
MR = dTR
dQ
MR = P * dQ + Q * dP
dQ dQ
MR = P + Q *dP
dQ
MR = P  1 + Q * dP 
P dQ
Remember: Ed = dQ . P
dP Q
1 = dP . P
Ed dQ Q
MR = P [ 1 + 1 ]
(Ed)
MR = p [ 1- 1 ] , where e = Ed
e
When e > 1: MR > 0
e < 1 : MR < 0
e = 1: MR = 0
Therefore, it can be concluded that the monopolist always operates on the elastic portion
of the demand curve, where MR > 0
5.2.4 Costs
In the traditional theory of monopoly the shapes of cost curves are the same as in the
theory of pure competition. The AVC, MC, and ATC are U-shaped, while AFC is a
rectangular hyperbola.
One point that should be stressed is that the MC curve is not the supply curve of the
monopolist, as in the case of pure competition. In monopoly there is no unique
relationship between price and quantity supplied. To put the same thing differently, a
monopolist has no supply curve at all.
5.2.5 Equilibrium of the Monopolist
A. Short-run Equilibrium
The monopolist maximizes his short-run profit if the following two conditions are fulfilled
1. MR = MC
2. The slope of MR (dMR ) is less than the slope of the MC ( dMC) , i.e
dQ dQ
dMR < dMC

dQ dQ
Profit or Loss in the short run.
Earlier, we argued that, profit would be maximized if (i.) MR=MC, and (ii) the slope of
MC is greater than the slope of the MR curve. In the context of economic theory,
however, maximum profit does not always imply positive profit. Like a perfectly
competitive firm a monopolist can make either positive, zero or even negative profit at
the profit maximizing level of output in the short-run. This is because the monopolist is
constrained both by demand and the input market.
A monopolist can’t freely set both its price and its quantity at any level to maximize
profit for it has no control over demand. Once the monopolist set the price, he/she must
adjust output in response to the market demand for the product. Besides demand, the
input market and technology also limit the operation of the monopolist. These constraints
may result in any one of the three outcomes.
Figure 1.2 shows the case of a monopolist that makes a positive profit.
Figure 1.2 A positive Profit Monopolist
Birr
P B SMC
SATC
C E
O Q MR D(AR) Quantity
Fig 1.2. Short – run equilibrium of monopolist
In the above fig 1.2. the equilibrium of the monopolist is defined by point E, at which
the MC intersects the MR curve from below. Thus, price P* will be charged and an
amount of Q* output will be produced and supplied. The monopolist will realize
excess profit of an amount equal to the shaded area.
Profit we argued will be maximized at the level of output and price for which marginal
revenue (MR) and marginal cost (MC) are equal. On the figure the two are equal at point
E. Q represents the profit maximizing level of output. It is determined by drooping a
perpendicular from point E to the quantity axis. P represents the corresponding profit
maximizing price. It is determined by extending the perpendicular up to the demand or
average revenue curve, point B, and reading its value on the price axis.
Total revenue obtained from the sale of Q units of output is by definition OQ multiplied
by OP i.e., the product of price and quantity. The area of rectangle OP BA provides the
total revenue of the monopolist. Total cost of production of the profit maximizing level
of output is O Q multiplied by OC, the product of quantity and average cost of
production. The area of rectangle OCE Q measures the total cost. Total profit of the
monopolist in this case, is given by the area PBEC. Since total revenue exceeds total cost
profit is positive.
In this case of a monopoly, price is set above the marginal cost of production. Thus
consumers are paying more than the true cost of production. Possession of an enormous
degree of monopoly power, as we said earlier, does not always ensure a positive
economic profit. The state of market demand, or of costs, or of both, may force a zero
profit on the monopolist.
Figure 1.3. A zero Profit Monopolist
Birr
SATC
P A
 D(AR)
0 Q RE Quantity
The tangency of the average cost and average revenue or price at point A in the figure
shows that the maximized total economic profit is zero. Any other price would result in a
negative profit. Note that, the expression zero profit does not mean that the monopolist
receives no returns. The cost curves contain the required normal profit.
A monopolistic zero profit has some features in common with the competitive zero profit
solution. (See Figure) In both cases, the short run average total cost curve (SATC) is
tangent to the average revenue or the demand curve. This indicates that the average
revenue (price) is equal to the average cost, hence, consumers pay no more than the true
cost of production. But a monopolistic zero profit solution has some important aspects
that distinguishes it from perfect competition.
Since the demand curve under monopoly, is a negatively sloped one, the average total
cost can be tangent to it at the range where its slope is negative. This means that the plant
cannot be operated at its lowest cost of production. Since tangency, when it does occur,
must be to the left of the minimum point of the short run average total cost, there is an
inefficient operation of plants which takes the form of under utilization. A monopolist
may have to accept losses in the short run.
If the short run average variable cost curve was to lie entirely above the average revenue
curve, the firm would be unable to cover not only the fixed cost but also part of its
variable cost and would improve its financial position by closing.
Mathematical Derivation of Equilibrium of the monopolist

Given the demand function,
P = f (Q)
and given the cost function
C = f(Q)
The monopolist aimed at the maximization of its profit

 = TR - TC
a) The first order condition for maximum profit  is
FOC: d = 0
dQ
d (TR – TC ) = 0
dQ
dTR dTC
dQ - dQ = 0
MR - MC = 0
MR = MC
b) The Second order condition for maximum profit it is

d2 < 0
dQ2
d2( TR – TC) < 0
dQ2
d2TR - d2TC <0
dQ2 dQ2
dMR - dTC <0

dQ dQ
dMR < dTC

dQ dQ
The slope of The Slope of
MR < MC
c) Long-run Equilibrium
Long-run equilibrium of a monopolist is the same as short-run equilibrium where MR
is equal to MC, provided that the MC cuts the MR from below. In the long – run the
monopolist has the time to expand its plant, or to use its existing plan at any level
which will maximize his profit. What is certain is that the monopolist will not stay in
business if it makes losses in the long-run; it will most probably continue to earn
supernormal profits even in the long-run, given that entry is blocked.
The equilibrium condition for a monopolist where it sells its product at two different
market is given by:
MR1 = MR2 = MC
If, however, there are N markets the equilibrium condition will be given by:
MR1 = MR2 = …=MRN =MC
The numerical example on price discrimination will be discussed during class room
discussion
Multiplan Monopolist
So far we have assumed that there is only one plant where the monopolist produce its
output , but sells at different markets. Since the monopolist operates only in a single
plant, there exists only one cost structure, hence the equilibrium condition is given by:
MR1 = MR2 = MC
However, let's assume that the monopolist operates with two different plants and sells its
output for only a single market. Let's also assume that the monopolist knows its cost
structure with certainly and the objective of the firms is profit maximization.
The equilibrium condition for a multiplant monopolist will be
MR = MC1 = MC2 = … = MC
The mathematical derivation of a multi plant monopolist, which operates only in two
different plant, and numerical example will be discussed during the normal class
discussion.
Social Cost of Monopoly
From the society point of view, monopoly is inefficient in allocating factors of production
as compared to perfect competition. The monopolist produces less amount of output and
charges higher price as compared to perfect competitive firm.
The extent of monopolist inefficiency is measured by the concept of consumer's and
producer's surplus
Consider the following diagram during session
p
O
Q0 Q1 Q
Welfare of society in perfect competition = C.S + P.S
Welfare of society in Monopoly = C.S + P.S
Change in Welfare of = Welfare of Society - Welfare of Society

Society in Monopoly in Perfect Competition
eg =-( C+E)
Thus, welfare has declined by the area C and E. Note that the area B is not lost,
rather transferred from CS to PS
The area C + E is known as Dead Weigh Loss. It's a loss neither gained by the
producer nor by the consumer. It is a loss to society.
5.3. MONOPOLICTIC COMPETITION
In the first part of this course we examined two "pure" market structures: Perfect Competition and
Pure Monopoly. We defined perfect Competition as the form of market organization in which
there are many sellers of a homogeneous product. Moreover, we defined Pure Monopoly as a
single seller of a commodity for which there are no close substitutes. Between these two extreme
forms of market organization lies monopolistic competition and oligopoly. In this chapter we
consider monopolistic competition. It refers to the case in which there are many sellers of a
heterogeneous or differentiated product & entry into or exit from the industry is rather is easy in
the long run. In summary, an industry is characterized as a monopolistically competitive if:
 there are many buyers and sellers.
 each firm in the industry (or Product group) produces differentiated product that are close
substitute.
 there are free entry into and exit from the industry.
Thus, monopolistic competition is a market structure in which a relatively large number of small
producers are offering similar, but not identical products. Note: as the name implies,
monopolistic competition is a blend of (perfect) competition & monopoly. The Competitive
element arises because:
there are many sellers in the market, each of which is too small to affect the other
sells, and
Firms can enter & leave a monopolistically competitive industry easily in the
long-run.
The monopolistic element arises from product differentiation. That is, since the product of each
seller is similar but not identical, each seller has a monopoly power over the specific product it
sells.
Chamberlin made other heroic assumptions of monopolistic competition. That is,
 all firms face the same demand conditions which implies that consumers' preferences are
evenly distributed among different sellers; and
 all firms also face the same cost conditions, i.e. the differences in products does not give
rise to differences in costs.
These assumptions help to show the equilibrium of the firm and market on the same diagram.
1.1 Product Differentiation & the Demand Curve
Differentiated Products are products that are similar but not identical. The similarity of
differentiated products arises from the fact that they satisfy the same basic consumption needs.
Examples include numerous brands of breakfast cereals, toothpaste, cigarettes and cold medicines
on the market today. The product differentiation may be real (when the inherent characteristics
of the products are different) or imaginary (when the products are basically the same but
consumers are persuaded that the products are different)
 The real differentiation exists when there are differences in the:
 Specification of products, or
 Factor inputs used, or
The case of the various breakfast cereals with various nutritional and sugar contents is best
example of real differentiation.
 Imaginary (Fancied) differentiation is established by:
 Advertising, or
 Differences in packaging, or
 Differences in product design, or
 Brand name; example: The case of different brands of aspirin, all of
which contain the same ingredients.
Demand Schedule: since the product of each seller is similar but not identical, each seller has a
monopoly power over the specific product it sells. This monopoly power, however, is severely
limited by the existence of close substitutes. Thus, these product differentiations create brand
loyalty of consumers and give rise to downward sloping elastic demand curve. That is, consumers
are willing to pay a higher price to enjoy the advantage of product differentiation. Since this
differentiation is slight the firm faces highly elastic demand curve.
Price
Highly elastic
demand curve
0 quantity
Industry and Product Group

Because each firm produces a somewhat different product under monopolistic competition, we
cannot define the industry, which refers to the producers of identical product. To overcome this
difficulty, Chamberlin redefined industry as a "product-group"- a group of firms/producers
producing similar (or closely related) products. Here, for simplicity we will continue to use the
term "industry" (to refer to all the sellers of the slightly differentiated products in a product
group).
1.2 Price & Output Determination in the Short-run and Long run
Before we examine equilibrium of monopolistically competitive firm let us briefly explain some
basic concepts.
*Costs: Chamberlin adopts the shape of costs of the traditional theory of the firm. That is, ATC,
AVC and MC curves are all U-shaped; and AFC has a geometric hyperbola shape.
*Actual-Sales (or share- of the market) Demand Curve: It is also called proportional (or
prorata) demand curve. It shows the actual sales of a firm at each price after accounting for the
adjustments of the prices of other firms in the group. Alternatively, it is the amount of demand
going to a typical firm when all firms are charging the same price. Here all firms adjust price
simultaneously but independently.
*Perceived (or Planned) demand curves: the amount of demand going to a typical firm when
there is no a simultaneous price adjustment by other firms.
1.3. Short-Run and Long-run Equilibrium
Short-Run Equilibrium: Just like any other firm, the monopolistically competitive firm will
produce as long as the marginal (extra) revenue from selling output exceeds the extra (marginal)
cost of producing that output. In the short-run, maximum profit (or equilibrium) occurs when
these extra revenue (MR) and extra costs (MC) are equal. See point E of figure (a) below. In
general, short-run equilibrium conditions are:
 MR = MC and MC is rising, &
 Proportional demand curve intersects perceive demand curve.
Graphical illustration of equilibrium:
P/C
P/C
MC
D D
MC AC
AC
Pe C A
Pe
A
B
d
E e
d
D D
Q 0 Q
0 Qe Qe
MR MR
Figure (a)—short run equilibrium Panel (b)—Long run equilibrium

1. Given the long-run equilibrium proportional demand curve P = 51-2q and LATC curve ATC(q) =
q2 – 16q + 100 for a firm in a monopolistic competition:
a) What is the long-run equilibrium price and quantity?
5.4. OLIGOPOLY
Definition: Oligopoly is the form of market organization in which there are few sellers of
homogeneous or differentiated product. If there are only two sellers in the market, we have a
duopoly. That is, duopoly is a special case of oligopoly in which there are only two sellers in the
market. If the product is homogeneous, we have a pure oligopoly. If the product is
differentiated, we have a differentiated oligopoly.
Because there are only few firms selling a homogeneous or differentiated product in oligopolistic
markets, the action of each firm affects the other firms in the industry, and vice versa. Thus, it is
clear that the distinguishing characteristic of oligopoly is the interdependence or rivalry among
firms in the industry. This interdependence is the natural result of fewness.
The sources of oligopoly are generally the same as for monopoly, that is:
1. Economies of scale, which enable few firms supplying the entire market.
2. Huge capital investment & specialized inputs are required to enter oligopolistic industry
(eg. Automobiles, aluminum, steel, ...)
3. Patent right (exclusive right to produce a commodity or to use a particular
production process).
4. Established firms may have loyal following customers
5. Control over entire supply of raw materials.
6. The government may award a franchise to only few firms to operate.
Types of Oligopoly: In general, oligopoly market is divided into two broad categories:
I. Non-collusive Oligopoly: in which firms may be better rivals of each other through
advertising, product differentiation, and so on.
II. Collusive Oligopoly: in which firms form coalition and cooperate.
5.4.1. NON-COLLUSIVE OLIGOPOLY
Since an oligopolist knows that its own actions will have a significant impact on the other
Oligopolists in the industry, each oligopolist must consider the possible reaction of competitors in
deciding its pricing policies, the degree of product differentiation to introduce, the level of
advertising to undertake, & so on.
Because competitors can react in many different ways, we do not have a single oligopoly model.
Here we present some of the most important Oligopoly models:
A) Cournot's Model (lies between competition & monopoly)
B) The Stackelberg model (extension of Cournot model).
C) The "Kinked-Demand" model
D) Bertrand's Model (similar with perfect competition)
A. COURNOT'S DUOPOLY MODEL

The French Economist Augustin Cournot introduced the first formal oligopoly model (in 1838).
He made the following assumptions to illustrate his model.
1) For simplicity, Cournot assumed that there are only two firms (duopoly)- A & B- selling
identical spring water, and operating with zero costs.
2) They sell their output in a market with a straight-line downward sloping demand curve.
3) Each firm, while trying to maximize profits, assumes that the other duopolist holds its
output constant at existing level. In other words, firms are assumed never to learn from
past experience, which makes their behavior at least naive.
NOTE: Each firm produces 1/(n+1) of the total output that would be supplied to the market at
P=MC=0; industry supply will be n[1/(n+1)] of output that would be supplied to the
market at P = MC = 0.
NB: The assumption of cost less production is unrealistic. But it can be relaxed without
impairing the validity of the model. This is illustrated with the help of the reaction-curves
approach.
Definition: Reaction curve of firm A is the locus of points of highest profits that firm A can
attain, given the level of output of rival firm, say B. Similarly, reaction curve of firm B shows
how much output firm B must produce in order to maximize its own profit, given the level of
output of its rival, firm A.
EQUILIBRIUM OF THE DUOPOLIST
QB Cournot's equilibrium is determined by the intersection

of the two reaction curves. It is a stable equilibrium,
provided that A's reaction curve is steeper than B's
A’s Reaction reaction curve.
curve NB: At point e each firm maximizes its own profit.
The action & reaction of the duopolists leads toward
point e.
Be e
B2
B1 B’s Reaction
curve
0 A A2 A1 QA
Mathematical Derivation of Reaction Curves:
Suppose the market demand facing the Duopolist is: Q = a + bP, where Q = market output, P =
price & b = slope, which is less than zero. Assume also that the two duopolists have different
costs:
C1 = f1(Q1), and C2 = f2(Q2).
Thus, 1 = R1 - C1 ------ the first duopolist profit function &
2 = R2 - C2 ----- the 2nd duopolist profit function
Note: R1 = PQ1 and R2 = PQ2 , and Q1 + Q2 = Q
i) The first duopolist maximizes his profit by assuming second firm's output (Q 2) constant,
irrespective of his own decisions; while the second duopolist maximizes his profit by
assuming that Q1 will be remain constant.
The first -order (necessary) condition for profit maximization of each duopolist is:
1 =  (R1-C1)= R1 - C1 =0, and

Q1 Q1 Q1 Q1
2 =  (R2-C2)= R2 - C2 =0, and

Q2 Q2 Q2 Q2
NB: R1 = MR1, R2 =MR2, C1 = MC1 & C2 = MC2
Q1 Q2 Q1 Q2
Thus, 1 = MR1 - MC1 = 0  MR1 = MC1 .......... (1)

Q1
And 2 = MR2 - MC2 = 0  MR2 = MC2 .............. (2)

Q2
Solving from expression (1) for Q1, we obtain Q1 as a function of Q2 & hence we
obtain 1st firm's reaction function.
Solving from the 2nd equation for Q2 we obtain Q2 as a function of Q1, which
represents 2nd firm's reaction function.
Finally, solving the reaction functions of the two duopolists simultaneously we obtain
the Cournot stable equilibrium; that is, the values of Q1 & Q2 which satisfies both
equations.
ii) The second-order (sufficient) conditions for equilibrium are:

 2 1  2 R1  2C1  2 R1  2C1  2 2  2 R2  2C2
0  0  ; and 0 
Q12 Q12 Q12 Q12 Q12 Q22 Q22 Q22
That is, MC must cut MR curve from below, or (Slope of MR) < (Slope of MC) for both
duopolists.
Example 1: Assume that the market demand equation is given as: Q = 12-P, where Q = total
quantity of spring water sold in the market & P is the market price. Suppose that spring water is
supplied with zero costs. Thus, MC is zero for the two firms, A & B.
a) Find the reaction function of both firms.
b) Compute QA & QB that leads to Cournot stable equilibrium.
Solution: Q = 12-P or P = 12- Q, where QA + QB = Q

Q = 12 - QA - QB
a) Revenue of A: RA = PQA = (12 - QA - QB)QA
RA = 12QA -Q2A - QAQB; and hence A = RA - CA = 12QA - Q2A -
QAQB
Revenue of B: RB = PQB = (12 - QA - QB)QB
RB = 12QB - QAQB – Q2B ; and hence B = RB - CB = 12QB -
QAQB - Q2B
i) Necessary condition for maximum profits is:

A = 0, and B = 0
QA QB
A = (12QA - Q2A - QAQB) = 0  12 -2QA - QB = 0 .......(1)

QA QA
B =  (12QB - QAQB - Q2B) = 0 12 -QA -2QB = 0 ...... …(2)

QB QB
Solving for QA from expression (1) , we get A's reaction function, i.e.
QA = 12 - QB ------------- (3) A's reaction function
Solving for QB from equation (2), we obtain B's reaction function

i.e. QB = 12 - QA ------- (4) B's reaction function
2
b) The Cournot equilibrium can be obtained by substituting duopolist B's reaction function
into duopolist A's reaction function (equation 3 ). Doing this, we get:
QA = 12 - (12 - QA)/2 = 12 - (6 - 0.5QA) = 12 - 6 + 0.5QA

2 2 2
QA = 6 + 0.5QA = 3 + 0.25QA  3 + QA = QA
Multiplying both sides by 4 we get:

4QA = 12 + QA  4QA -QA = 12  3QA = 12; thus, QA = 12/3 = 4
With QA = 4, QB = (12- QA)/2 = (12 – 4)/2 = 8/2 = 4
So that, QA = QB = 4 (Cournot equilibrium).
But P = 12 - Q, where Q = QA + QB = 8 (Industry out put)

Thus, P = 12 - 8 = $4 Each duopolist will sell spring water at P = $4
B. THE STACKELBERG MODEL:
Heinrich Stackelberg (German economist) made an important extension to the Cournot model.
Stackelberg assumed that one of the duopolists, say duopolist A, knows that duopolist B behaves
in the naive Cournot fashion (i.e., firm A knows B's reaction function) and uses that knowledge in
choosing its own output. Duopolist A is then called the Stackelberg leader, duopolist B is
referred to as the Stackelberg follower. All the other assumptions of the Cournot model hold.
This model shows that duopolist A will have higher profits than under Cournot solution at the
expense of duopolist B (the Stackelberg follower).
The Stackelberg leader substitutes the follower's reaction function in market demand equation
and solve for his output (QA). The resulting expression is the demand function facing duopolist A
(the leader). Then, as usual cases the leader maximizes profit by equating his MR to his MC.
C. BERTRAND DUOPOLY MODEL:

Bertrand’s duopoly model (which was developed in 1883) differs from Cournot’s in that it
assumes that each firm expects that the rival will keep its price, irrespective of its own decision
about pricing. Each firm is faced by the same market demand, and aims at the maximization of its
own profit on the assumption that price of the competitor will remain constant. In this case the
firm chooses price in stead of quantities (unlike case of Cournot). Like the Cournot model, the
Bertrand model duopoly model applies to firms that produce homogenous product.
Because products are homogenous, consumers purchase only from the lowest price seller. Thus,
if the two firms charge different prices, the higher priced firm will sell nothing. If both firms
charge the same price, consumers will be indifferent as to which firm they buy from. And it is
assumed that each will supply half the market. In general, this model leads to price competition
over time. Each firm tries to cut price to capture the entire market share. Thus, all will seek to
undercut their rivals and a price cutting war will result. Firms will stop cutting their prices only
when competitive price level is reached. In other words, Bertrand’s equilibrium is at a perfectly
competitive price such that no further price cutting occurs.
Consider the following example where the market demand for a good is: P = 80 – Q, where Q =
Q1+Q2; and both firms have a constant MC of 10. Thus, if price is below this MC, there will be an
incentive to reduce price with the intension of capturing more market share. This price cut will
continue until it equals MC, which is, of course, a competitive price. Thus, for Bertrand
equilibrium occurs when P = MC = 10, and over all equilibrium output equals 70 (Q=80-P),
where each firm supplies half of the market; i.e. Q1=Q2= Q/2=70/2 = 35 units.
5.4.2. CULLUSIVE OLIGOPOLY
One way of avoiding uncertainty (eg. price war) arising from oligopolistic interdependence is to
enter into collusive agreements. There are two types of collusion: Cartels and Price Leadership
Models. Collusion can be explicit or tacit (implicit).
2.1 Cartel: is a combination of firms whose objective is to limit the scope of competitive
forces within a market. There are two forms of Cartels:
A) Centralized Cartel (cartels aiming at joint profit maximization), and
B) Market-sharing cartel.
A) Centralized Cartel: operates as a monopolist. It is a formal organization of producers of

a commodity whose purpose is to coordinate the policies of the member firms so as to increase
joint or industry profits. The centralized cartel appoints a central agency to which they delegate
the authority to decide:
 the monopoly price for the commodity & monopoly output.
 the allocation of monopoly output among the member firms
 the share (distribution) of monopoly profits among member firms.
Note that the agency:

 will have access to the cost figures of individual firms,
 knows the market demand curve from which he estimates marginal revenue.
Thus, total marginal cost is obtained by the horizontal summation of each firm's in the cartel. We
consider a homogeneous commodity or pure oligopoly. Industry (monopoly) price & output is
determined by equating market MR and industry MC (= SMC). Consider two firms form a
cartel.
Given the market demand (DD) & each firm's MC in figure above the monopoly solution, which
maximizes joint profits, is determined by the intersection of total MC & MR (point e). The total
output is Qm and it will be sold at P . The central agency allocates the production (Q m) among
firm A & firm B by equating the common MR to the individual marginal costs (i.e. MR = MC 1 =
MC2; see point e1 & e2). Thus, firm A will produce Q 1 and firm B will produce Q 2. Similarly, the
distribution of profits is decided by a central agency of the cartel
P/C P/C MC=MC1+MC2

p/c
Firm-A Firm-B D Market
AC1 MC2 AC2
MC1
P c P
d
f
g P
a b
MC1=MR MC2=MR e2 MC=MR e
e1
0 Q1 QA 0 Q2 QB 0 Qm=Q1+Q2 D Q
MR
mainly based on their cost structure. The shaded areas (or area abc P for firm A & area of dgf
P for firm B) of figures shown above represents profits of each firm. A total industry profit is
the sum of the profits of the two firms.
B) Market - Sharing Cartel

In a market - sharing cartel the member firms agree only on how to share the market, but keep a
considerable degree of freedom concerning the style of output, their selling activities & other
decisions.
There are two methods of sharing the market:

1) Non-Price competition, and
2) Determination of Quotas
1) Non-Price Competition: In this case the member firms agree on common price, at which
each firm can sell any quantity demanded. The price is set by bargaining, with the low - cost
firms pressing for a lower price & the high -cost firms for a high price. But the firms agree not to
sell at a price below the cartel price.
This form of Cartel is "loose" in the sense that it is more unstable than the complete cartel aiming
at joint profit maximization. This is because with cost differences, the low - cost firms will have
a strong incentive to break away from the Cartel openly & charge a lower price, or to cheat the
other firms (members) by secret price concessions to the buyers. Such cheating will soon be
discovered by the other members, who will gradually lose their customers. Therefore, others may
split from the cartel and price war and instability may develop.
2. Market-Sharing by Agreement on Quotas: This method represents the agreement

on the quantity that each member may sell at the agreed price (prices). If all firms have
identical costs, the monopoly solution will emerge, with the market being shared equally
among member firms; otherwise shares of the market will differ.
2.2. Price-Leadership:
In this form of coordinated behaviour of oligopolists one firm-usually the dominant or the largest
firm in the industry -initiates price changes, and allows all the other (small) firms to sell all they
want at that price.
There are two most common types of price-leadership:

a) Low -cost price -leadership &
b) Price -leadership by large (dominant) firm.
a) The low-cost price -leadership
In this model the firms may come to an agreement to share the markets equally or may agree to
have unequal shares. The important condition here is that the firms have unequal costs.
b) The Dominant Firm Price Leader

In the price leadership model by the dominant firm, the dominant firm sets the price for the
commodity that maximizes its profits, allows all the other smaller firms in the industry to sell all
they want at that price, and then comes in to fill the market. Thus, the small firms in the industry
behave as perfect competitors or Price-takers, and the dominant firm acts as the residual supplier
of the commodity.

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CHAPTER FIVE

5.1 Perfectly Competition Market Structure

5.1.1 Perfectly Competition is a market structure in which there is a complete absence of

Review of Some Basic Concepts:

1. The Firm’s Demand Curve:

3. Firm’s Cost Curve:

4. Equilibrium of the Firm

A. Short-run Equilibrium of the Firm:

Numerical illustration: Consider the following cost schedule of a certain competitive

(ii) Marginal Approach:

The Supply Curve of the Firm and the Industry:

Short-run Equilibrium of the Industry:

P/C P Industry Equlb.

Firm’s Long-run Equilibrium:

Monopoly is a market structure in which there is a single seller, there is no close

5.2.2. Source of Monopoly

Example: Suppose input X is required to produce output Y. If one firm has

II. Legal Barriers – includes patents, franchise and government licenses:-

5.2.3. Demand and Revenue

Q = a-b*P----------- demand Equation

b. At point D’ the elasticity is zero

c. Total Revenue of the monopolist

Take the inverse demand equation i.e.

Lets suppose a = c and 1 = d , thus

TR = c*Q – d*Q2 -------- Total Revenue Equation

d. The Average Revenue (AR) is the price

Thus, the demand curve is also the AR curve

e. The Marginal Revenue

g. The Relationship between MR and Price Elasticity (Ed) is

dMR < dMC

Figure 1.2 A positive Profit Monopolist

Fig 1.2. Short – run equilibrium of monopolist

Figure 1.3. A zero Profit Monopolist

Mathematical Derivation of Equilibrium of the monopolist

The monopolist aimed at the maximization of its profit

b) The Second order condition for maximum profit it is

dMR - dTC <0

dMR < dTC

Welfare of society in perfect competition = C.S + P.S

Welfare of society in Monopoly = C.S + P.S

Change in Welfare of = Welfare of Society - Welfare of Society

Industry and Product Group

Figure (a)—short run equilibrium Panel (b)—Long run equilibrium

A. COURNOT'S DUOPOLY MODEL

EQUILIBRIUM OF THE DUOPOLIST

QB Cournot's equilibrium is determined by the intersection

1 =  (R1-C1)= R1 - C1 =0, and

2 =  (R2-C2)= R2 - C2 =0, and

Thus, 1 = MR1 - MC1 = 0  MR1 = MC1 .......... (1)

And 2 = MR2 - MC2 = 0  MR2 = MC2 .............. (2)

ii) The second-order (sufficient) conditions for equilibrium are:

Solution: Q = 12-P or P = 12- Q, where QA + QB = Q

i) Necessary condition for maximum profits is:

A = (12QA - Q2A - QAQB) = 0  12 -2QA - QB = 0 .......(1)

B =  (12QB - QAQB - Q2B) = 0 12 -QA -2QB = 0 ...... …(2)

Solving for QB from equation (2), we obtain B's reaction function

QA = 12 - (12 - QA)/2 = 12 - (6 - 0.5QA) = 12 - 6 + 0.5QA

Multiplying both sides by 4 we get:

TR = cQ – dQ2 -------- Total Revenue Equation