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Essay Plan: Limits on Monopoly Power

Last updated 30 Oct 2019

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In this revision video we build an answer to this question: “Using applied examples of your choice, examine two factors that might limit the monopoly power of a business.”

In theory, a firm with monopoly power such as Coca Cola which has over 40 percent of the US carbonated drinks market, has huge scope to keep their prices higher than they might be if they faced more intensive competition and therefore earn high supernormal profits. The existence of barriers to entry in the market such as strong brand loyalty, patents and copyrights also means that these abnormal profits persist in the long run generating higher returns for shareholders perhaps at the expense of consumer welfare. Brand loyalty makes demand for a firm’s products more price inelastic and this allows a business to set prices higher and extract consumer surplus turning it into producer surplus.

However, one constraint on monopoly power can be the role played by industry regulators who might act as a surrogate competitor even in markets where the degree of contestability is low. A good example of this in the UK has been the energy price cap imposed by OFGEM on the leading electricity and gas suppliers in what is an oligopolistic industry. A price cap constrains what a firm can charge which - in theory - leads to lower prices and a reduced level of supernormal profit. This is shown in my analysis diagram - we can see that total profit is lower, prices down and output higher than under a single price profit maximising monopoly. The impact of a regulatory price cap depends on where the ceiling is set and also whether suppliers respond to maximum prices by successfully cutting their own operating costs to protect profit margins.

In some industries, monopoly power is strong because established firms can take advantage of internal economies of scale which reduces their long run average cost (LRAC) and gives them a significant cost advantage over smaller rivals and also potential entrants. Economies of scale lead to higher profits and also make it more difficult for competitor businesses to successfully enter an industry. A good example of this might be the leading commercial banks such as Barclays, Lloyds and HSBC all of whom - under normal economic circumstances - make very high profits of hundreds of millions of £s each year. There are some challenger banks in the industry such as Metro Bank, but many are finding it hard to growth quickly enough to become a genuine threat to the incumbent operators. If these new banks make little impact, then commercial banks with market power can continue to offer low interest rates for savers and also charge more for personal and business loans. In some industries - known as natural monopolies - economies of scale are vast implying that only one supplier can fully exploit them. In this case, competition is likely to remain limited and market power will remain strong in the long run.

However, although economies of scale can give established banks a built-in advantage, market power can be eroded by the impact of new technologies. An example of this can be seen in retail banking services with the relative success of tech-savvy businesses such as Starling and the App-only bank Monzo which is currently the fastest-growing bank in the UK with over 2.5 million customers with savings deposits of over £1 billion. Many challenger firms operate with a different business model to existing firms and they can compete aggressively in price and non-price terms by targeting better what larger firms may have ignored. Their operating costs are usually much lower and they are less at risk of experiencing diseconomies of scale or X-inefficiencies that often plague firms with a dominant market position. Indeed in many sectors, technological change is reducing the barriers to entry for smaller enterprises, many of whom can use internet platforms such as Amazon web services to sell direct to customers. If entry barriers are lower, then a market becomes more contestable and monopoly power is diminished.

• Complex monopoly
• Natural monopoly
• Local monopoly
• Pure Monopoly

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Perfect competition - short run price and output equilibrium.

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ECON101: Principles of Microeconomics (2021.A.01)

Introduction to a monopoly.

Read this chapter, which discusses monopolies. Be sure to click through to read the sections that follow the introduction.

5. Key Concepts and Summary

How monopolies form: barriers to entry.

Barriers to entry prevent or discourage competitors from entering the market. These barriers include: economies of scale that lead to natural monopoly; control of a physical resource; legal restrictions on competition; patent, trademark and copyright protection; and practices to intimidate the competition like predatory pricing. Intellectual property refers to legally guaranteed ownership of an idea, rather than a physical item. The laws that protect intellectual property include patents, copyrights, trademarks, and trade secrets. A natural monopoly arises when economies of scale persist over a large enough range of output that if one firm supplies the entire market, no other firm can enter without facing a cost disadvantage.

How a Profit-Maximizing Monopoly Chooses Output and Price

A monopolist is not a price taker, because when it decides what quantity to produce, it also determines the market price. For a monopolist, total revenue is relatively low at low quantities of output, because not much is being sold. Total revenue is also relatively low at very high quantities of output, because a very high quantity will sell only at a low price. Thus, total revenue for a monopolist will start low, rise, and then decline. The marginal revenue for a monopolist from selling additional units will decline. Each additional unit sold by a monopolist will push down the overall market price, and as more units are sold, this lower price applies to more and more units. The monopolist will select the profit-maximizing level of output where MR = MC, and then charge the price for that quantity of output as determined by the market demand curve. If that price is above average cost, the monopolist earns positive profits. Monopolists are not productively efficient, because they do not produce at the minimum of the average cost curve. Monopolists are not allocatively efficient, because they do not produce at the quantity where P = MC. As a result, monopolists produce less, at a higher average cost, and charge a higher price than would a combination of firms in a perfectly competitive industry. Monopolists also may lack incentives for innovation, because they need not fear entry.

Home — Essay Samples — Economics — Monopoly — Monopolies: Advantages and Disadvantages

Monopolies: Advantages and Disadvantages

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Published: Mar 20, 2024

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Advantages of monopolies, introduction, disadvantages of monopolies, impact on the economy and society, policy implications.

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12.5: Introduction to Profit and Losses in Monopolies

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What you’ll learn to do: calculate and graph a monopoly’s costs, revenues, profit and losses

We know that because a monopolist controls the market for a good or service, they get more say in how much they want to produce and what price to sell it at. In this section, you’ll see how they make those decisions.

• Introduction to Profit and Losses in Monopolies. Authored by : Steven Greenlaw and Lumen Learning. License : CC BY: Attribution
• Money!. Authored by : Thomas Galvez. Provided by : flickr. Located at : https://www.flickr.com/photos/togawanderings/5899676716/ . License : CC BY: Attribution

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• Prof. Jonathan Gruber

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• Microeconomics

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Principles of microeconomics, lecture 12: monopoly ii, description.

This lecture focuses on how monopolies arise, regulation of monopolies, and contestable markets. See Handout 12 for relevant graphs for this lecture. 

Instructors: Prof. Jonathan Gruber

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THE DYNAMICS OF PERFECT MARKETS GRADE 12 NOTES - ECONOMICS STUDY GUIDES

• Key concepts
• Review of production, costs and revenue
• Perfect competition
• The individual business and the industry
• Market structures
• Output, profit, losses and supply
• How to draw graphs to show various equilibrium positions
• Competition policies

A perfect market is characterised by perfect competition. The conditions that result in perfect competition include:

• Equal access to the technology required for production
• No barriers to entry or exit from the marketplace
• Accurate and available market information
• No participant with the power to set the market price
• According to equilibrium theory, a perfect market will reach an equilibrium where the quantity supplied equals the quantity demanded at the market price

6.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide. Understand these concepts well.

Use mobile notes to help you learn these concepts. Instructions for making them are on page xiv in the introduction.

6.2 Review of production, costs and revenue

Production takes place in the short run and the long run

• Short run The short run is the period of production where only the variable factors of production can change. The time period is too short to permit the number of firms in the industry to change.
• Long run The long run is the period of production where all factors can change. The time is long enough for variable and fixed factors to change. It allows enough time for new firms to enter the industry and/or existing firms to exit.

Table 6.1: Review of production, costs and revenue It is important to review production, cost and revenue concepts covered in Grade 11. This is vitally important for the understanding of cost and revenue curves for the different market structures which you will study in this section. Summary of costs

• The difference between the total cost and variable cost is the fixed cost
• TVC curve starts from 0 and TC starts from the fixed cost curve on the Y- axis.
• The gap between the AC curve and the AVC curve gets smaller as output increases.
• The MC Curve will always cut the AC and AVC curves at their minimum points.

6.3 Perfect competition

Perfect competition occurs in a market structure with a large number of participants who have access to all required information about the market place and are all price-takers. Prices are determined by demand and supply. Examples of market structures demonstrating most conditions of a perfect competition include the stock exchange, the foreign exchange market, the central grain exchange, and agricultural produce markets. A perfect market is a market where no single buyer or seller has a noticeable influence on the price of a good. This gives a true reflection of the scarcity value of goods and services. 6.3.1 Characteristics/conditions of a perfect market Products must be homogenous (i.e. identical)

• Products must be identical. There should be no differences in style, design and quality.
• In this way products compete solely on the basis of price and can be purchased anywhere.

There should be a large number of buyers and sellers

• It should not be possible for one buyer or seller to influence the price.
• When there are many sellers the share of each seller in the market is so small that the seller cannot influence the price.
• Sellers are price takers, they accept the prevailing market price. If they increase prices above the market price, they will lose customers.

No preferential treatment/discrimination

• Collusion occurs when buyers and sellers make an agreement to limit competition. In a perfect market no collusion takes place.
• Buyers and sellers base their actions solely on price, homogenous products fetch the same price and therefore no preference is shown for buying from or selling to any particular person.

Free competition

• Buyers must be free to buy whatever they want from any firm and in any quantity.
• Sellers must be free to sell what, how much and where they wish.
• There should be no State interference and no price control.
• Buyers should not form groups to obtain lower prices, nor should sellers combine to enforce higher prices.

Efficient transport and communication

• Efficient transport ensures that products are made available everywhere.
• In this way changes in demand and supply in one part of the market will influence the price in the entire market.
• Efficient communication keeps buyers and sellers informed about market conditions.

All participants must have perfect knowledge of market conditions

• All buyers and sellers must be fully aware of what is happening in any part of the market.
• Technology has increased competition as information is easily obtained via the internet.

Free access to and from markets

• Producers may enter and leave a market with little interference.
• Entering and leaving a perfect market is easy as less capital is required and there are fewer legal restrictions.

The factors of production are completely mobile

• They can move freely between markets.

In reality there are few perfect markets, however there are some sectors such as mining (e.g. gold) and agriculture (e.g. maize) where many of the conditions are met. These sectors illustrate the way in which the market mechanism works.

6.4 The individual business and the industry

6.4.1 Determining the market price To determine the market price for a firm under perfect competition you need to draw two graphs next to each other. On the left is the graph for the industry and on the right is the graph for the firm (individual producer).

• Figure 6.2 a) (the industry) shows the interaction of demand and supply (market forces).
• The market forces are in equilibrium at the point of intersection of the demand and supply curves, at “e”.
• At equilibrium the quantity demanded is equal to the quantity supplied. This determines the market price.
• Now look at Figure 6.2 b) (firm or individual producer). One producer will not be able to influence the market price and has to accept the market price (P1), he is a price taker.
• Because this is the only price the producer can charge, the demand curve for the producer is a straight line drawn at price P1.
• This horizontal line at the market price (P1) is the demand curve (DD), the average revenue (AR) curve and the marginal revenue (MR) curve.

Read this section on graphs through five times, and redraw each graph each time. 6.4.2 Demand curve for an individual producer The individual producer is a price taker and sells goods at the market price. At this price, demand remains constant. A higher price such as P2 cannot be charged as customers will be lost to other producers. A lower price such as P3 cannot be charged as a small profit or a loss will be made.

• At all pionts where MR is above MC, the firm is adding to profit. From unit 1-3, the firm is increasing its profit.
• At all points where MC is above MR, the firm is decreasing profit. From unit 5-7, the firm’s profit will decrease.
• The firm maximises profit where MR = MC. The firm maximises its profits at unit 4.

Table 6.5: Depicting Profit Maximisation

• If TC > TR the business makes a loss. If TR > TC it makes a profit.
• Maximum profit is achieved at units 3 and 4.
• Once the maximum profit is achieved, profits start to decrease with the next unit of output.
• Therefore the firm will not produce more than 4 units.
• At all points where TR is above TC, the firm is making a profit.
• At all points where TC is above TR, the firm is making a loss.
• The gap between TR and TC represents profit.
• Profit is maximised when the gap between TR and TC is the greatest. This is occurs at between 3 and 4 units.

6.5 Market structures

There are FOUR different market structures:

• Monopolistic competition

Table 6.6 shows the 5 broad characteristics which distinguish the four market structures: As you study each market structure in detail, you will be able to identify more distinguishing characteristics.

6.6 Output, profit, losses and supply

• Given a market price of P3, profit is maximised where MR = MC = P 3.
• This occurs at a quantity of Q 3 .
• At Q 3 the firm’s average revenue (AR) per unit of production is P 3,
• The average cost per unit is C 1 which is lower than the price of P 3.
• The firm is making an economic profit per unit of production of P 3 – C 1.

Another explanation

• Total revenue equals P 3 × Q 3, therefore total revenue is represented by the area 0P 3 E 3 Q 3 .
• Total cost equals C 1 × Q 3, this is represented by the area 0C 1 MQ 3.
• The difference between these two areas is the economic profit which is represented by the light grey shaded area C 1 P 3 E 3 M.

When Average Revenue is above Average cost the firm makes an ECONOMIC PROFIT.

• Given a market price of P 3, profit is maximised where MR = MC at point E 3.
• This occurs at a quantity of Q 3.
• At Q3 the firm’s average revenue (AR) per unit of production is P 3,
• The average cost per unit is C 3 which is higher than the price of P 3.
• The firm is making an economic loss per unit of production which is equal to the difference between C 3 and P 3.

Another explanation.

• Total revenue equals P 3 × Q 3, therefore total revenue is represented by the area 0P 3 E 3 Q 3.
• Total cost equals C 3 × Q 3, this is represented by the area 0C 3 MQ 3.
• The difference between these two areas is the economic loss which is represented by the light grey shaded area C 3 P 3 E 3 M.
• Whether the firm should continue production would depend on the level of AR (that is P3) relative to the firm’s average variable cost.

3. Normal profits

• A firm makes normal profits when total revenue (TR) equals total costs or when average revenue (AR) equals average cost (AC).
• Normal profit is the maximum return the owner of a firm expects to receive to keep on operating in the industry.
• Given a market price of P 2, profit is maximised where MR = MC = P 2.
• This occurs at a quantity of Q 2.
• At Q2 the firm’s average revenue (AR) per unit of production is P2, which is also equal to the average cost per unit C 2 (AC).
• Since AR = AC, the firm earns a normal profit since all its costs are fully covered.
• Point E 2 is usually called the break-even point.
• Total revenue equals P2 x Q2, therefore total revenue is represented by the area 0P2E2Q2.
• Total cost equals C2 × Q2, this is represented by the area 0P2E2Q2.
• Since Total revenue equals Total Cost the producer makes a normal profit.

The individual business can make an economic profit, economic loss or normal profit in the Short Run. They are referred to as short run equilibrium positions. In the long run the individual business will always make normal profit. 6.6.2 The industry The long term equilibrium for the industry and the individual firm The impact of entry and exit on the equilibrium of the firm and industry

• Profits are a signal for the entry of new businesses.
• Losses are a signal for businesses to leave the market.
• The long-term equilibrium in the perfect market will be influenced by the entry or exit of individual businesses.
• If individual farmers are earning an economic profit at P 1.
• New farmers will enter the market, more apples will be supplied.
• The market supply curve will shift to the right from S 1 to S 2.
• The Equilibrium price will drop from P 1 to P 2.
• Individual farmers will then earn normal profits. There will be no further reason for new farmers to enter the market. The industry is in equilibrium.
• If individual farmers are making economic losses, some farmers may leave the industry.
• When a few farmers leave the market, fewer apples will be supplied.
• The market supply curve will shift to the left from S 1 S 1 to S 2 S 2.
• The equilibrium price will increase from P 1 to P 2. Individual farmers will then earn normal profits. There will be no reason for individual farmers to leave the market.
• Therefore in a perfect market the long term equilibrium is achieved when individual firms earn a normal profit.
• Point a: a firm will not produce here because AR < AVC
• Point b: it is the lowest price that the firm will charge (shut-down point). It represents the beginning of the supply curve.
• Point c: the firm is making an economic loss. Because AR < AC. The loss is minimised because the firm produces where MR = MC.
• Point d: the firm is making normal profit (breaking even) because AR = AC.
• Point e: the firm is making economic (supernormal) profits because AR > AC.

6.7 How to draw graphs to show various equilibrium positions

First draw your TWO axes: Price (P) on the vertical axis and Quantity (Q) on the horizontal axis. Remember, they meet at the origin (0). Note that the labelling of the axes is not the same for all graphs. In showing the various equilibrium positions the following sequence should be followed.

• Draw the demand curve followed by the Marginal revenue curve, (in a perfect market D = MR = AR).
• Then draw the AC curve.
• Then draw the MC curve which must cut the AC curve at its minimum point.
• Identify profit maximising point. MC = MR
• Determine quantity (drop a line from the profit maximizing point to the x-axis).
• Determine price (extend line upwards from the profit maximizing point to the demand curve) and then extend the line horizontal to the y-axis.
• Compare AR/price to AC to determine profit or loss.

Everything is important – do not leave out anything! Each step counts for marks. Label all axes, curves and graphs. Note the following:

• To show economic profit the AC curve must cut the demand curve.
• To show normal profit the minimum point on AC curve must be at a tangent to the demand curve.
• To show economic loss the AC curve must not touch demand curve.

6.8 Competition policies

6.8.1 Description Competition refers to the existence of free entry into and exit from markets. This ensures that markets are not dominated by certain businesses. 6.8.2 Goals of competition policy

• To prevent monopolies and other powerful businesses from abusing their power.
• To regulate the formation of mergers and acquisitions who wish to exercise market power.
• To stop firms from using restrictive practices like fixing prices, dividing markets etc.

6.8.3 The Competition Act in South Africa The government introduced the Competition Act 89 of 1998 to promote competition in South Africa in order to achieve the following objectives:

• promote the efficiency of the economy (its primary aim)
• provide consumers with competitive prices and a variety of products
• promote employment
• encourage South Africa to participate in world markets and accept foreign competition in South Africa
• enable SMMEs to participate in the economy
• to allow the previously disadvantaged to increase their ownership of businesses
• Define the concept market structure. (2)
• How many sellers will one find in a monopoly market? (2)
• In what market are all participants price-takers? Motivate your answer. (4)
• Explain the shape of the individual demand curve under perfect competition. (4)
• Vodacom (6)
• Explain in your own words the message behind the pie-charts shown above. (4)

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Essay on Oligopoly: Top 8 Essays on Oligopoly | Markets | Microeconomics

Here is a compilation of essays on ‘Oligopoly’ for class 9, 10, 11 and 12. Find paragraphs, long and short essays on ‘Oligopoly’ especially written for school and college students.

Essay on Oligopoly

Essay Contents:

• Essay on Payoff (Profit) Matrix

Essay # 1. Introduction to Oligopoly:

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Two extreme market forms are monopoly (characterised by the existence of a single seller) and perfect competition (characterised by a large number of sellers). Competition is of two types- perfect competition and monopolistic competition. In perfect competition, all sellers sell ho­mogeneous products while in monopolistic competition they sell heterogeneous products. In monopoly there is no rival.

So the monopolist is not concerned with the effect of his actions on rivals. In both types of competition, the number of firms is so large that the actions of any one seller have little, if any, effect on its competitors. An industry with only a few sellers is known as an oligopoly, a firm in such an industry is known as an oligopolist.

Although car-wash is a million rupee business, it is not exactly a product familiar to most consumers. However, often many familiar goods and services are supplied only by a few com­peting sellers, which means the industries we are talking about are oligopolies. An oligopoly is not necessarily made up of large firms. When a village has only two medi­cine shops, service there is just as much an oligopoly as air shuttle service between Mumbai and Pune.

Essentially, oligopoly is the result of the same factors that sometimes produce monopoly, but in somewhat weaker form. Honestly, the most important source of oligopoly is the exist­ence of economies of scale, which give better producers a cost advantage over smaller ones. When these economies of scale are very strong, they lead to monopoly, but when they are not that strong they lead to competition among a small number of firms.

Since an oligopoly con­tains a small number of firms, any change in the firms’ price or output influences the sales and profits of competitors. Each firm must, therefore, recognise that changes in its own policies are likely to elicit changes in the policies of its competitors as well.

As a result of this interdependence, oligopolists face a situation in which the optimal deci­sion of one firm depends on what other firms decide to do. And so there is opportunity for both conflict and cooperation. Oligopoly refers to a market situation in which the number of sellers is few, but greater than one. A special case of oligopoly is monopoly in which there are only two sellers.

Essay # 2. Characteristics of Oligopoly:

The notable characteristics of oligopoly are:

1. Price-Searching Behaviour :

An oligopolist is neither a price-taker (like a competitor) nor a price-maker (like a monopolist). It is a price-searcher. An oligopolist is neither a big enough part of the market to be able to act as a monopolist, nor a small enough part of the market to be able to act as a competitor. But each firm is a dominant part of the market.

In such a situation, competition among buyers will force all the sellers to charge a uniform price for a product. But each firm is sufficiently so large a part of the market that its actions will have noticeable effects upon his rivals. This means that if a single firm changes its output, the prices charged by all the firms will be raised or lowered.

2. Product Characteristics :

In oligopoly, there may be product differentiation as in monopolistic competition (called differ­entiated oligopoly) or a homogeneous product may be traded by all the few dominant firms (as in pure oligopoly).

3. Interdependence and Uncertainty :

In oligopoly no firm can take decision on price independently. It is because the decision to fix a new price or change an existing price will create reactions among the rival firms. But rivals’ reactions cannot be predicted accurately. If a firm reduces its price its rivals may reduce their prices or they may not. So there is lack of symmetry in the behaviour of rival firms.

This type of reaction of rivals is not found in perfect competition or monopolistic competition where all firms change their price in the same direction and by the same magnitude in order to remain competitive and survive in the long run. So the outcome of a firm’s decision is uncertain.

For this reason it is difficult to predict the total demand for the product of an oligopolistic industry. It is still more difficult, and in some situations virtually impossible, to estimate the share of an individual firm in industry’s output.

It is true that the consequences of attempted price variations on the part of an individual seller are uncertain. His rivals may follow his change, or they may not, but they will, in all likelihood, notice it. The results of any action on the part of an oligopolist or even a duopolist depend upon the reactions of his rivals. In short, it is not possible to define general price- quantity relations for an individual firm, since reaction patterns of rivals are highly uncertain and almost completely unknown.

4. Different Reaction Patterns and Use of Models :

It is not true to say that, in oligopoly, profit is always maximised. It is because an oligopolist does not have control over all the variables which affect his profit. Moreover, a variety of possible reaction patterns is possible in this market—there is a conjectural variation in this market.

Just as firm A’s profit depends on the output of firm B also, firm B’s profit, in its turn, depends on firm A’s output. This is why various models are used to describe the diverse behaviour of oligopoly markets where a variety of outcomes is possible.

5. Non-Price Competition :

As in monopolistic competition there is not only price competition but non-price competition as well in oligopoly (and, to some extent, in duopoly). For example, advertising is often a life and death question in this type of market due to strategic behaviour of all firms. In most oligopoly situations we find intermediate outcomes. Economists are yet to emerge with a definite behaviour pattern in oligopoly.

Essay # 3. Scope of Study of Oligopoly :

Here we study a few of the many possible reaction patterns in duopoly and oligopoly situa­tions. The focus is on pure oligopoly. Here we assume that all firms produce a homogeneous product. We do not discuss the case of differentiated oligopoly and the issue of selling cost (advertising) separately. Of course, we discuss briefly Baumol’s sales maximisation hypoth­esis—without and with advertising.

The focus here is on the interdependence of the various sellers’ reactions, which is the essential distinguishing feature of oligopoly. If the influence of one seller’s quantity decision from the profit of another, δπ i /δq j , is negligible, the industry must be either perfectly competi­tive or monopolistically competitive. If δπ i /δq j , is perceptible, the industry is duopolistic or oligopolistic.

The optimum quantity and maximum profit of a duopolist or oligopolist depend upon the actions of the firms belonging to the industry. He can control only his own output level (or price, if his product is differentiated), but he has no direct control over other variables which are likely to (or do) affect his profits. In truth, the profit of each oligopolist is the result of the interaction of the decisions of all players in the market.

Since there are no generally accepted behavioural assumptions for oligopolists and duopolists as is found in other market forms, there are diverse patterns of behaviour and many different solutions for oligopolistic and duopolistic markets. Each solution is based on different types of models and each model is based on a different behavioural assumption or a set of assumptions.

Here we start with one or two simple duopoly models. The same analysis (solution) can be extended to cover any oligopolistic market. The earliest model of duopoly behaviour is the Cournot model, with which we may start our review of different oligopoly models. We end with the game theoretic treatment of oligopoly which shows decision-making under conflict.

Essay # 4. Models of Oligopoly:

1. the cournot model :.

The Cournot model (presented in 1838) is based on the analysis of a market in which two firms produce a homogeneous product. Augustin Cournot (a French economist) noticed that only two firms were producing mineral water for sale. He argued that each firm would choose quan­tity that would maximise profit, taking the quantity marketed by its competitor as given.

Two main features of the model are:

(i) Each firm chooses a quantity of output instead of price; and

(ii) In choosing its output each firm takes its rival’s output as given.

In Cournot’s model, then, strategies are quantities of output. Here we assume that firms produce a homoge­neous good and know the market demand curve.

Each firm must decide how much to produce, and the two firms make their decisions at the same time. When taking its production decision, each duopolist takes into consideration its competitor. It knows that its competitor is also de­ciding how much to produce, and the market price will depend on the total output of both firms.

The essence of the Cournot model is that each firm treats the output level of its competitor as fixed and then decides how much to produce. Each Cournot’s duopolist believes that the other’s quantity will not change. In Fig. 1 when I produces Q M , II maximises its profit by producing 1/4Q C . In order to sell Q M plus Q c , the price must fall to P 1 . Here Q M is the mo­nopoly output which is half the competitive output Q c .

The inverse demand function, stating price as a function of the aggregate quantity sold, is expressed as:

P =f (q 1 ) + q 2 … (1)

where q 1 and q 2 are the output levels of the duopolists. The total revenue of each duopolist depends upon his own output level as also as that of his rival:

R 1 = q 1 f 1 (q 1 + q 2 ) = R 1 (q 1 , q 2 )

R 2 = q 2 f 2 (q 1 + q 2 ) = R 2 (q 1 , q 2 ) … (2)

The profit of each equals his total (sales) revenue, less his cost, which depends upon his output level above:

π 1 = R 1 (q 1 , q 2 ) – C 1 (q 1 )

π 2 = R 2 (q 1 , q 2 ) – C 2 (q 2 ) … (3)

The basic behavioural assumption of the Cournot model is that each duopolist maximises his profit on the assumption that the quantity produced by his rival is invariant with respect to his own decision regarding output quantity. Duopolist I maximises π 1 with reference to q 1 , treating q 2 as a parameter, and duopolist II maximises π 2 , with reference to q 2 , treating q 1 as a parameter. Setting the partial derivatives of (3) equal to zero, we get:

The solution of (7) is

Here OM is the marginal cost of producing the commodity. The second firm’s price is p 2 . The first firm’s profit function is composed of three segments. When p 1 < p 2 , the first firm captures the entire mar­ket, and its profit increases as its price increases. When p 1 > p 2 , the two firms split the total profits equal to distance CA, and each makes a profit equal to CB. When p 1 >p 2 , the first firm’s profit is zero because it sells nothing when its price exceeds the second firm’s price.

Criticisms:

The Bertrand model has been criticised on two main grounds. First, when firms produce a homogeneous good, it is more natural to compete by setting quantities rather than prices. Second, even if firms do set prices and choose the same price (as the model predicts), what share of total sales will go to each one? The model assumes that sales would be divided equally among the firms, but there is no reason why this must be the case.

However, despite these shortcomings, the Bertrand model is useful because it shows how the equilibrium out­come in an oligopoly can depend crucially on the firms’ choice of strategic variable.

3. The Stackelberg Model :

The Stackelberg model (presented by the German economist Heinrich von Stackelberg) is a modified version of the Cournot model. In the Cournot model, we assume that two duopolists make their output decisions at the same time. The Stackelberg model examines what happens if one of the firms can set its output first. The Stackelberg model of duopoly is different from the Cournot model, in which neither firm has any opportunity to react.

The model is based on the assumption that the profit of each duopolist is a function of the output levels of both:

π 1 = g 1 (q 1 , q 2 ) π 2 = g 2 (q 1 , q 2 ) … (1)

The Cournot solution is found out by maximising π 1 with reference to q 1 , assuming q 2 to be constant and π 2 with reference to q 2 , assuming q 1 to be constant. In general, each firm might make some other assumption about the response (reaction) of its only rival. In such a situation, profit-maximisation by the two duopolists requires the fulfillment of the following two condi­tions:

Since the firm’s demand curve is kinked, its combined marginal revenue curve is discon­tinuous. This means that the firm’s cost can change without leading to price change. In this figure, marginal cost could increase but would still equal marginal revenue at the original out­put level. This means that price remains the same.

The kinked demand curve model fails to explain oligopoly pricing. It says nothing about how marginal revenue firms arrived at the original price P̅ to start with. In fact, some arbitrary price is taken as both the starting and end point of our journey. Why firms did not arrive at some other price remains an open question. It just describes price rigidity but cannot explain it. In addition, the model has not been supported by empirical tests. In reality, rival firms do match price increases as well as price cuts.

Market-sharing Price Leadership :

Oligopolists often collude—jointly restrict supply to raise price and cooperate. This strategy can lead to higher profits. Collusion is, however, illegal. Moreover, one of the main impedi­ments to implicitly collusive pricing is the fact that it is difficult for firms to agree (without talking to each other) on what the price should be.

Coordination becomes particularly problem­atic when cost and demand conditions—and, thus, the ‘correct’ price—are changing. However, benefits of cooperation can be enjoyed without actually colluding. One way of doing this is through price leadership. Price leadership may be provided by a low-cost firm or a dominant firm.

In this context, we may draw a distinction between price signalling and price leadership. Price signalling is a form of implicit collusion that sometimes gets around this problem. For example, a firm might announce that it has raised its price with the expectation that its competi­tors will take this announcement as a signal that they should also raise prices. If competitors follow, all of the firms (at least, in the short run) will earn higher profits.

At times, a pattern is established whereby one firm regularly announces price changes and other firms in the industry follow. This type of strategic behaviour is called price leadership— one firm is implicitly recognised as the ‘leader’. The other firms, the ‘price followers’, match its prices. This behaviour solves the problem of coordinating price: Everyone simply charges what the leader is charging.

Price leadership helps to overcome oligopolistic firms’ reluctance to change prices—for fear of being undercut. With changes in cost and demand conditions, firms may find it increas­ingly necessary to change prices that have remained rigid for some time. In that case, they wait for the leader to signal when and by how much price should change.

Sometimes a large firm will naturally act as a leader; sometimes different firms will act as a leader from time to time. In this context, we may discuss the dominant Firm model of leadership. This is known as market- sharing price leadership.

6. The Dominant Firm Model :

In some oligopolistic markets, one large firm has a major share of total sales while a group of smaller firms meet the residual demand by supplying the remainder of the market. The large firm might then act as a dominant firm, setting a price that maximises its own profits.

The other firms, which individually could exert little, if any, influence over price, would then act as perfect competitors; they all take the price set by the dominant firm as given and produce accordingly. But what price should the dominant firm set? To maximise profit, it must take into account how the output of the other firms depends on the price it sets.

Fig. 5 shows how a dominant firm sets its prices. A dominant firm is one with a large share of total sales that sets price to maximise profits, taking into account the supply response of smaller firms. Here D is the market demand curve and S F is the supply curve (i.e., the aggregate marginal cost curves of the smaller firms, called competitive fringe firms). The dominant firm must determine its demand curve D D .

This curve is just the difference between market demand and the supply of fringe firms. For example, at price P 1 , the supply of fringe firms is just equal to market demand. This means that the dominant firm can sell nothing at this price. At a price P 2 or less, fringe firms will not supply any of the good, in which case, the dominant firm faces the market demand curve. If price lies between P 1 and P 2 , the dominant firm faces the demand curve D D .

The marginal cost curve of the dominant firm corresponding to D D is MR D . The dominant firm’s marginal cost curve is MC D . In order to maximise its profit, the dominant firm produces quantity Q D at the interaction of MR D and MC D . From the demand curve D D , we find P 0 . At this price, fringe firms sell a quantity Q F , thus the total quantity sold is Q T = Q D + Q F .

7. Collusive Oligopoly: The Cartel Model :

Various models have been formulated to explain the strategic behaviour of firms in an oligopolistic market. A price (cut-throat) competition exists among the rivals who try to oust the others from the market. Sometimes there ex­ists a dominant firm that acts as the leader in the market while the others just follow the leader.

As a result, there happens to be a clear possibil­ity of the formation of a cartel by the rival firms in an oligopolistic market in order to eliminate competition among themselves. This is termed as “collusive oligopoly” because the firms some­how manage to combine together in order to be­have collectively as a single monopoly.

Now let us see graphically what incentives the firms get for forming a cartel. In Fig. 6, the market demand curve is given by the D M the total supply curve is the horizontal summation of the marginal cost curves of all existing firms in the industry, which is denoted by MC M .

The market equilibrium is attained at the point of intersection between the D M (demand curve) and the marginal cost curve MC M , if the firms compete with each other. OP M is the equilibrium price at which the total output of the industry is OQ M .

In order to determine its own quantity, each firm equates this price to its marginal cost. The sum of the quantities of the firms is OQ. If the firms form a cartel in order to act as a monopolist, the price rises to OP ‘ M and the quantity is reduced to OQ ‘ M to be in equilibrium. Now, when the quantity is being reduced by Q M Q’ M , then all the firms together save the cost represented by the area below the MC M curve which is Q M E M F M Q ‘ M .

Thus, a rise in price due to a reduction in the quantity is followed by a decrease in the total revenue represented by the area below the MR M curve, i.e., area Q M G M F M Q’ M . This, in turn, shows that the cost saved exceeds the loss in revenue and, so, all the firms taken as a whole can increase their profit represented by the area E M F M G M . The prospect of earning this extra profit actually acts as the incentive to form a cartel in the oligopoly market structure.

Since the cartel is formed, all firms agree together to produce the total quantity OQ’ M . In order to carry this out, each and every firm is allotted a quota or a certain portion of production such that the sum of all quotas is equal to OQ M . For this, the best way of quota allotment would be to treat each firm as a separate entity (plant) under the same monopolist. Thus, all the firms have the same marginal cost (MC) such that MC = MR (marginal revenue).

Finally, the total profit is maximised because the total output is produced at the minimum cost.

Each and every firm can increase its profit by reducing the profits of other firms, simply by increasing its output quantity above the allotted quota. The system of cartel formation must guard against the desire of individual firms to violate the quota and the cartel breaks down when the cost of guarding against quota violation is very high.

The OPEC is an example of collusive oligopoly or cartel in which members (producers) explicitly agree to cooperate in setting prices and output levels. All the producers in an industry need not and often do not join the cartel. But if most producers adhere to the cartel’s agree­ments, and if market demand is sufficiently inelastic, the cartel may drive prices well above competitive levels.

Two conditions for success:

Two conditions must be fulfilled for cartel success. First, a stable cartel organisation must be formed whose members agree on price and production levels and both adhere to that agreement. The second condition is the potential for monopoly power. A cartel cannot raise price much if it faces a highly elastic demand curve. If the potential gains from cooperation are large, cartel members will have more incentive to share their organisa­tional problems.

Analysis of Cartel Pricing:

Cartel pricing can be analysed by using the dominant firm model of oligopoly. It is because a cartel usually accounts for only a portion of total production and must take into account the supply response of competitive (non-cartel) producers when it sets price. Here we illustrate the OPEC oil cartel.

Fig. 7 illustrates the case of OPEC. Total demand TD is the world demand curve for crude oil, and S c is the competitive (non-OPEC) supply curve. The demand for OPEC oil D 0 is the difference between total demand (TD) and competitive supply (SC), and MR 0 is the corresponding marginal revenue curve.

MC 0 is OPEC’s marginal cost curve; OPEC has much lower production costs than do non-OPEC producers. OPEC’s marginal revenue and marginal cost are equal at quantity Q 0 , which is the quantity that OPEC will produce. Here we see from OPEC s demand curve that the price will be P 0 .

Since both total demand and non-OPEC supply are inelastic, the demand for OPEC oil is also fairly inelastic; thus the cartel has substantial monopoly. In the 1970s, it used that power to drive prices well above competitive levels.

In this context, it is important to distinguish between short-run and long-run supply and demand curves. The total demand and non-OPEC supply curves in Fig. 7 apply to short-or intermediate-run analysis. In the long run, both demand and supply will be much more elastic, which means that OPEC’s demand curve will also be much more elastic.

We would thus expect that, in the long run, OPEC would be unable to maintain a price that is so much above the competitors’ level. In truth, during 1982-99, oil prices fell steadily, mainly because of the long- run adjustment of demand and non-OPEC supply.

However, cartel is not an unmixed blessing. No doubt cartel members can talk to one an­other in order to formalize an agreement. But it is not that easy to reach a consensus. Different members may have different costs, different assessments of market demand, and even different objectives, and they may, therefore, want to set prices at different levels.

Furthermore, each member of the cartel will be tempted to “cheat” by lowering its price slightly to capture a larger market share than it was allotted. Most often, only the threat of a long-term return to competi­tive prices deters cheating of this sort. But if the profits from cartelization are large enough, that threat may be sufficient.

Essay # 5. Sales (Revenue) Maximisation :

W.J. Baumol presented an alternative hypothesis to profit maximisation, viz., sales (revenue) maximisation. He has suggested that large oligopolistic firms do not maximise profit, but rather maximise sales revenue, subject to the constraint that profit equals or exceeds some minimum accepted level. Various empirical studies support Baumol’s hypothesis. And it accurately cap­tures some aspects of oligopolistic firms’ behaviour.

Most important, when firms are uncertain about their demand curve they actually face, or, when they cannot accurately estimate the marginal costs of their output (due to uncertainty about factor prices, or when they produce more than one product), the decision to try to maximise sales appears to be consistent with their long-term survival. This is why many oligopolist firms seek to maximise their market share in order to protect themselves from the adverse effects of uncertain market environment.

Graphical Analysis :

A revenue-maximising oligopolist would choose to produce that level of output for which MR = 0. When MR = 0, TR is maximum. That is, the oligopolist should proceed to the point at which selling any extra unit(s) actually leads to a fall in TR. This choice is illustrated in Fig. 8.

For the firm which faces the demand curve D, TR is maximum when output is q s . For q < q s , MR is positive. This means that selling more units increases TR (though not necessarily profit). For q > q s , however, MR is negative. So further sales actually reduce TR because of price cuts that are necessary to induce consumers to buy more. We know that

MR = P(1 – 1/e p ) … (1)

MR = 0 if e p = 1, in which case TR will be maximum. TR is constant in a small neighbourhood of that output quantity at M 1 P = 0, TR is maximum, and when TR is maximum, e p = 1.

We may now compare the revenue-maximisation choice with the profit-maximising level of output, q s . At q p , MR equals marginal cost MC in Fig. 8. Increasing output beyond q p would reduce profits since MR < MC. Even though TR continues to increase up to q s , units of output beyond q p bring in less than they cost to produce. Since marginal revenue is positive at q p , equation (1) shows that demand must be elastic (e p > 1) at this point.

Essay # 6. Constrained Revenue Maximisation :

A firm that chooses to maximise TR is neither taking into account its costs nor the profitabil­ity of the output that it is selling. And it is quite possible that the output level q s in Fig. 8 yields negative profit to the firm. However, it is not possible to any firm to survive for ever with negative profits. So it may be more realistic to assume that firms do meet some mini­mum level (target rate) of profit from their activities.

Thus, even though oligopolists may be prompted to produce more than q p with a view to maximising revenue, they may produce less than q p units in order to ensure an acceptable level of profit. They will, therefore, behave as constrained revenue maximises and will choose to produce an output level which lies between q p and q s .

Mathematical Analysis :