Introduction to Monopolies and Oligopolies

In the news lately, stories of the big bad monopolies abound. We constantly hear of government regulation in software, utilities, transportation, and financial institutions. The justice department closely scrutinizes mergers and acquisitions so that firms don't end up with too much market power. All of this begs the question, what's the big deal? Where does our fear of monopolies originate? After all, in a free market economy, there is no coercion. Presumably, the economy is still driven solely by mutually beneficial exchange whether one firm exists or many. Thus far in our treatment of economics, we have assumed that there exist a large number of firms in a market. This assumption enabled us to treat firms as price takers, since no firm in particular had any more market power than any other. In this Sparknote, we will investigate the impact of a relaxation of the multiple firms assumption on equilibrium. We will demonstrate the importance of the assumption in our understanding of perfect competition. In the first section, we will define a monopoly and walk through the mechanics behind calculating equilibrium in a monopolistic market. We will also investigate the monopoly's impact on social welfare. In the second section, we extend the model of a monopoly to 2 firms and then to n firms. We define the assumptions underlying Cournot, Bertrand, and Stackelberg duopolies. We then walk through examples designed to clarify the mechanics behind the various models of duopoly, and generalize to the n firm case in a Cournot framework.

Terms
Pure monopoly - A firm that satisfies the following conditions: 1. It is the only supplier in the market. 2. There is no close substitute to the output good. 3. There is no threat of competition. Natural monopoly - A firm with such extreme economies of scale that once it begins creating a certain level of output, it can produce more at a lower cost than any smaller competitor. Generally characterized by a declining average cost curve. Economies of scale - Savings acquired through increases in quantity produced. Oftentimes, large firms in industries with high fixed costs can take advantage of savings that smaller firms cannot. Price taker - An agent who takes prices as given. For instance, a firm who faces a perfectly flat demand curve has no choice but to sell at one price. This firm is a price taker. Perfect competition - A market operates under perfect competition if it satisfies the following conditions: 1. Numerous firms

2. Freedom of entry and exit 3. Homogeneous output 4. Perfect information Deadweight loss - The dollar amount of social surplus that goes unrealized as compared to the socially optimal solution. Price setter - The opposite of a price taker; a price setter has the power to set prices. For instance, a firm who faces a downward sloping demand curve can choose price. Socially optimal - Describes points at which social surplus is maximized, social surplus being the combined utilities of the firms and the public. Oligopoly - A market dominated by a small number of firms. At least several of these firms are large enough to influence the market price. Duopoly - A market dominated by two firms. Both firms are large enough to influence the market price. Cournot duopoly - A model of duopolies under which two firms simultaneously choose the quantity to produce. Stackelberg duopoly - A model of duopolies under which two firms choose the quantity to produce with one firm choosing before the other in an observable manner. Bertrand duopoly - A model of duopolies under which two firms simultaneously choose the price for a good. Cartel - A small number of independent firms who act together to set monopoly prices and make monopoly profits. Public information - Information known to everyone. Reaction curve - A reaction curve is a function that takes as input the moves of the other players and returns the optimal move given the other players' moves. Nash equilibrium - An equilibrium in which all players are playing their best responses to everyone else's best response.

Monopolies

Pure Monopolies and Natural Monopolies

Pure Monopolies
A pure monopoly is a firm that satisfies the following conditions: 1. It is the only supplier in the market. 2. There is no close substitute to the output good. 3. There is no threat of competition. In practice, pure monopolies are very rare. For instance, a supermarket may be the only food supplier in a particular town, but if it raises its prices and retains too much of a profit, a competitor may enter the space. Even the threat of serious competition entering the market forces the existing firm to act conscionably, and differently from how it would

act otherwise. A train company may be the only carrier in a particular station, but if cars are also available in the area, there exists a close substitute to the output good.

Natural Monopoly
A natural monopoly is a firm with such extreme economies of scale that once it begins creating a certain level of output, it can produce more at a far lower cost than any smaller competitor. Natural monopolies exist far more frequently than pure monopolies, mainly because the requirements are not as stringent. Natural monopolies occur when, for whatever reason, the average cost curves decline over a relevant span of output quantities. A firm with high fixed costs relative to its marginal costs will have declining average costs for a significant span of quantities. A firm with a decreasing marginal cost structure will also have declining average costs. For example, utilities and software are two industries where natural monopolies occur often.

An Example
A monopoly differs from competitive firms in that it is not a price taker. Because it is the only supplier in the market, it faces a downward sloping demand curve, the market demand curve. As a result, the monopoly is free to choose its price and quantity according to market demand. Monopolies are still profit maximizing firms and are thus going to satisfy the profit maximizing condition that marginal cost equal marginal revenue. The key to understanding monopolies and monopoly power is the marginal revenue calculation. In a perfectly competitive market, there exists a market price. Marginal revenue is simply equal to price in this market; every additional unit that is sold brings the market price. In a monopoly, however, every quantity is associated with a different price. The marginal revenue is not simply the price. For example, I may be able to sell 10 guitars at 100each, butinordertosell11guitars, Iwillhavetoofferapriceof 95. Unfortunately, it's very difficult to sell 10 guitars at 100andthensellthelastoneat 95. In our model of a monopoly, there can only be one price for a good. If I choose to sell 11 units, I make 95revenueonthe11thguitar, butIlose 5 revenue on each of the first 10 guitars. If it costs me 50toproduceaguitar, mymarginalrevenueisthen 95 - 50 = 45. Let's generalize. Assume that a monopolistic firm faces a linear, downward- sloping market demand curve, described as follows: Q = 100 - P Let's further assume its marginal cost curve is constant at a value of 10. MC = 10

Our firm naturally wants to maximize profits and will therefore aim to satisfy the profit maximizing condition, MC = MR . Marginal costs are constant at ten, so half of our equation is easy. To find our marginal revenue, we first look at the total revenue. Total revenue is simply: R=P*Q Because the monopolist faces the entire market demand curve, price and quantity have a one-to-one relationship. That is, P = 100 - Q . We can rewrite our total revenue as: R = (100 - Q) * Q = 100 * Q - Q^2 The marginal revenue is simply the first derivative of the total revenue with respect to Q . MR = 100 - 2 * Q If you don't feel comfortable with derivatives, you can convince yourself this MR is correct by analyzing its components. MR = (100 - Q) - Q (100 - Q) is the price according to our market demand curve. This 100 - Q represents the marginal revenue brought in by selling the next unit. However, in order to sell the next unit, we had to lower the price by 1 for all units sold (the demand curve has a slope of -1, so the tradeoff between Q and P is 1 for 1). Therefore, on the margin, we lost 1 unit of revenue for all Q units sold. The marginal revenue is then (100 - Q) - Q = 100 - 2*Q . To solve for the monopolistic equilibrium, we find the quantity at which MR = MC . Solving: 100 - 2 * Q = 10 => Q = 45 At this quantity, the market price would be 100 - 45 = 55 . Assuming no fixed costs, the profits for this firm would be 45*(55 - 10) = 2025 . Naturally, this is a vast improvement for the firm over the competitive outcome of zero profits.

Welfare Analysis
So what's wrong with making profits? Certainly, profits are good for the monopolistic firms. The consumers are willing to pay for the goods at the monopoly price. Nobody is being forced to do anything, so we have a system of mutually beneficial exchange with no coercion. I think it would be overstepping our bounds for SparkNotes to say there is something wrong with monopoly power, but the foundations for government intervention in monopolistic markets can be found in welfare analysis.

Let's identify the deadweight loss in the example from the previous section. Let Q m be the output quantity chosen by the monopolist, 45 in this market. Let Q * be the output quantity at which the marginal cost curve intersects the market demand curve. Q * = 90 in this market. Q * is the socially optimal output quantity. Imagine the firm is trading at a quantity less than Q * . At this point, the marginal cost curve is below the demand curve. In other words, the marginal cost to society is less than the marginal benefit (the demand curve). The society stands to gain by trading at a higher quantity. The opposite is true at quantities greater than Q * (convince yourself of this). Remember that Q m is no greater than, and most often less than, Q * . If Q m is less than Q * , it is suboptimal. The deadweight loss is the area between the demand curve and the marginal cost curve over the quantities between Q m and Q * . The marginal cost is the marginal cost to society, and the marginal benefit is the demand curve. Over these quantities, the marginal benefit is greater than the marginal cost, so the area between the curves represents social surplus unrealized at the monopolistic equilibrium. The impact of monopolistic behavior on social welfare varies with the shape of the demand curve. For example, with a perfectly inelastic demand curve, the market cannot help but trade at the socially optimal quantity. However, the monopolist has the power to set prices as high as it pleases (for this reason, many of these industries are regulated, such as suppliers of insulin or water). Therefore, there exists no deadweight loss, but all social surplus is absorbed by the monopolistic firm. A monopolist's power is determined by its ability to set prices, which relies completely on the demand curve a firm faces. In perfect competition, a firm sees a flat demand curve and therefore does not have a practical choice as to what price to offer. The monopolist's power comes from facing a downward sloping demand curve.

Duopolies and Oligopolies

Overview
Monopoly power comes from a firm's ability to set prices. This ability is dictated by the shape of the demand curve facing that firm. If the firm faces a downward sloping demand curve, it is no longer a price taker but rather a price setter. In our perfect competition model, we assume there exist multiple participants, and because there are so many participants, the slice of the demand curve each firm sees is but a flat line. These firms are price takers. There is a medium between monopoly and perfect competition in which only a few firms exist in a market. None of these firms faces the entire demand curve in the way a monopolist would, but each does have some power to set prices. A small collection of firms who dominate a market is called an oligopoly. A duopoly is a special case of an oligopoly, in which only two firms exist.

Duopolies
We will begin our discussion with an investigation of duopolies. For the following duopoly examples, we will assume the following: 1. 2. 3. 4. 5. The two firms produce homogeneous and indistinguishable goods. There are no other firms in the market who produce the same or substitute goods. No other firms can or will enter the market. Collusive behavior is prohibited. Firms cannot act together to form a cartel. There exists one market for the produced goods.

Cournot Duopoly
In 1838, Augustin Cournot introduced a simple model of duopolies that remains the standard model for oligopolistic competition. In addition to the assumptions stated above, the Cournot duopoly model relies on the following: 1. Each firm chooses a quantity to produce. 2. All firms make this choice simultaneously. 3. The model is restricted to a one-stage game. Firms choose their quantities only once. 4. The cost structures of the firms are public information. In the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. Both firms know the market demand curve, and each firm knows the cost structures of the other firm. The essence of the model is this: each firm takes the other firm's choice of output level as fixed and then sets its own production quantities. The best way to explain the Cournot model is by walking through examples. Before we begin, we will define the reaction curve, the key to understanding the Cournot model (and elementary game theory as well). A reaction curve for Firm 1 is a function Q 1 *() that takes as input the quantity produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's production decisions. In other words, Q 1 *(Q 2) is Firm 1's best response to Firm 2's choice of Q 2 . Likewise, Q * 2 (Q 1) is Firm 2's best response to Firm 1's choice of Q 1 . Let's assume the two firms face a single market demand curve as follows: Q = 100 - P where P is the single market price and Q is the total quantity of output in the market. For simplicity's sake, let's assume that both firms face cost structures as follows: MC_1 = 10 MC_2 = 12

Given this market demand curve and cost structure, we want to find the reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and proceed. Firm 1's reaction curve will satisfy its profit maximizing condition, MR = MC . In order to find Firm 1's marginal revenue, we first determine its total revenue, which can be described as follows Total Revenue = P * Q1 = (100 - Q) * Q1 = (100 - (Q1 + Q2)) * Q1 = 100Q1 - Q1 ^ 2 - Q2 * Q1 The marginal revenue is simply the first derivative of the total revenue with respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for Firm 1 is thus: MR1 = 100 - 2 * Q1 - Q2\ Imposing the profit maximizing condition of MR = MC , we conclude that Firm 1's reaction curve is: 100 - 2 * Q1* - Q2 = 10 => Q1* = 45 - Q2/2 That is, for every choice of Q 2 , Q 1 * is Firm 1's optimal choice of output. We can perform analogous analysis for Firm 2 (which differs only in that its marginal costs are 12 rather than 10) to determine its reaction curve, but we leave the process as a simple exercise for the reader. We find Firm 2's reaction curve to be: Q2* = 44 - Q1/2 The solution to the Cournot model lies at the intersection of the two reaction curves. We solve now for Q 1 * . Note that we substitute Q 2 * for Q 2 because we are looking for a point which lies on Firm 2's reaction curve as well. Q1* = 45 - Q2*/2 = 45 - (44 - Q1*/2)/2 = 45 - 22 + Q1*/4 = 23 + Q1*/4 => Q1* = 92/3 By the same logic, we find: Q2* = 86/3 Again, we leave the actual computation of Q 2 * as an exercise for the reader. Note that Q * and Q 2 * differ due to the difference in marginal costs. In a perfectly competitive 1 market, only firms with the lowest marginal cost would survive. In this case, however, Firm 2 still produces a significant quantity of goods, even though its marginal cost is 20% higher than Firm 1's. An equilibrium cannot occur at a point not in the intersection of the two reaction curves. If such an equilibrium existed, at least one firm would not be on its reaction curve and would therefore not be playing its optimal strategy. It has incentive to move elsewhere, thus invalidating the equilibrium.

The Cournot equilibrium is a best response made in reaction to a best response and, by definition, is therefore a Nash equilibrium. Unfortunately, the Cournot model does not describe the dynamics behind reaching equilibrium from a non-equilibrium state. If the two firms began out of equilibrium, at least one would have an incentive to move, thus violating our assumption that the quantities chosen are fixed. Rest assured that for the examples we have seen, the firms would tend towards equilibrium. However, we would require more advanced mathematics to adequately model this movement.

Stackelberg duopoly
The Stackelberg duopoly model of duopolies is very similar to the Cournot model. Like the Cournot model, the firms choose the quantities they produce. In the Stackelberg model, however, the firms do not move simultaneously. One firm holds the privilege to choose production quantities before the other. The assumptions underlying the Stackelberg model are as follows: 1. Each firm chooses a quantity to produce. 2. A firm chooses before the other in an observable manner. 3. The model is restricted to a one-stage game. Firms choose their quantities only once. To illustrate the Stackelberg model, let's walk through an example. Assume Firm 1 is the first mover with Firm 2 reacting to Firm 1's decision. We assume a market demand curve of: Q = 90 - P Furthermore, we assume all marginal costs are zero, that is: MC = MC1 = MC2 = 0 We calculate Firm 2's reaction curve in the same way we did for the Cournot Model. Verify that Firm 2's reaction curve is: Q2* = 45 - Q1/2 To calculate Firm 1's optimal quantity, we look at Firm 1's total revenues. Firm 1's Total Revenue = P * Q1 = (90 - Q1 - Q2) * Q1 = 90 * Q1 - Q1 ^ 2 - Q2 * Q1 However, Firm 1 is not forced to assume Firm 2's quantity is fixed. In fact, Firm 1 knows that Firm 2 will act along its reaction curve which varies with Q 1 . Firm 2's quantity very much relies on Firm 1's choice of quantity. Firm 1's Total Revenue can thus be rewritten as a function of Q 1 : R1 = 90 * Q1 - Q1 ^2 - Q1 * (45 - Q1/2)

Marginal revenue for firm 1 is thus: MR1 = 90 - 2 * Q1 - 45 + Q1 = 45 - Q1 When we impose the profit maximizing condition (MR = MC) , we find: Q1 = 45 Solving for Q 2 , we find: Q2 = 22.5 Although much of the logic behind the Stackelberg model is used in the Cournot model, the two outcomes are radically different: being the first to announce creates a credible threat. In the Cournot model, both firms make their choices simultaneously and have no communication beforehand. In the Stackelberg model, Firm 1 not only announces first, but Firm 2 knows that when Firm 1 announces, Firm 1's actions are credible and fixed. This demonstrates how a slight change in the flow of information can drastically impact the outcome of a market.

Bertrand Duopoly
The Bertrand duopoly Model, developed in the late nineteenth century by French economist Joseph Bertrand, changes the choice of strategic variables. In the Bertrand model, rather than choosing how much to produce, each firm chooses the price at which to sell its goods. 1. Rather than choosing quantities, the firms choose the price at which they sell the good. 2. All firms make this choice simultaneously. 3. Firms have identical cost structures. 4. The model is restricted to a one-stage game. Firms choose their prices only once. Although the setup of the Bertrand Model differs from the Cournot model only in the strategic variable, the two models yield surprisingly different results. Whereas the Cournot model yields equilibriums that fall somewhere in between the monopolistic outcome and the free market outcome, the Bertrand model simply reduces to the competitive equilibrium, where profits are zero. Rather than take you through a series of convoluted equations to derive this result, we will simply show there could be no other outcome. The Bertrand equilibrium is simply the no profit equilibrium. First, we will demonstrate that the Bertrand outcome is indeed an equilibrium. Imagine a market in which two identical firms sell at market price P, the competitive price at which neither firm earns profits. Implicit in our argument is our assumption that at equal price, each firm will sell to half the market. If Firm 1 were to raise its price above the market price P, Firm 1

would lose all its sales to Firm 2 and would have to exit the market. If Firm 1 were to lower its price below P, it would be operating below cost and therefore at a loss overall. At the competitive outcome, Firm 1 cannot increase profits by changing its price in either direction. By the same logic, Firm 2 has no incentive to change prices. Therefore, the no profit outcome is an equilibrium, in fact a Nash equilibrium, in the Bertrand model. We now demonstrate uniqueness of the Bertrand equilibrium. Naturally, there can be no equilibrium where profits are negative. In this case, all firms would operate at a loss and exit the market. It remains to be shown that there is no equilibrium where profits are positive. Imagine a market in which two identical firms sell at market price P, which is greater than cost. If Firm 1 were to raise its price above the market price P, Firm 1 would lose all its sales to Firm 2. However, if Firm 1 were to lower its price ever so slightly below P (while still remaining above MC), it would capture the entire market at a profit. Firm 2 is faced with the same incentives, so Firm 1 and Firm 2 would undercut each other until profits are driven to zero. Therefore no equilibrium exists when profits are positive in the Bertrand model.

Collusion
You may ask yourself why firms don't agree to work together to maximize profits for all rather than competing amongst themselves. In fact, we will show that firms do benefit when cooperating to maximize profits. Assume both Firm 1 and Firm 2 face the same total market demand curve: Q = 90 - P where P is the market price and Q is the total output from both Firm 1 and Firm 2. Furthermore, assume that all marginal costs are zero, that is: MC = MC1 = MC2 = 0 Verify that the reaction curves according to the Cournot model can be described as: Q1* = 45 - Q2/2 Q2* = 45 - Q1/2 Solving the system of equations, we find: Cournot Equilibrium: Q1* = Q2* = 30 Each firm produces 30 units for a total of 60 units in the market place. P is then 30 (recall P = 90 - Q ). Because MC = 0 for both firms, the profit for each firm is simply 900 for a total profit of 1,800 in the market. However, if the two firms were to collude and act as a monopoly, they would act differently. The demand curve and the marginal costs remain the same. They would act

together to solve for the total profit maximizing quantity Q . Revenues in this market can be described as: Total Revenue = P * Q = (90 - Q) * Q = 90 * Q - Q^2 Marginal Revenue is therefore: MR = 90 - 2 * Q Imposing the profit maximizing condition (MR = MC) , we conclude: Q = 45 Each firm now produces 22.5 units for a total of 45 in the market. The market price P is therefore 45. Each firm makes a profit of 1,012.5 for a total profit of 2,025. Notice that the Cournot equilibrium is much better for the firms than perfect competition (under which no one makes any profits) but worse than the collusive outcome. Also, the total quantity supplied is lowest for the collusive outcome and highest for the perfectly competitive case. Because the collusive outcome is more socially inefficient than the competitive oligopoly outcome, the government restricts collusion through anti-trust laws.

Extension of the Cournot Model

We now extend the Cournot Model of duopolies to an oligopoly where n firms exist. Assume the following: 1. Each firm chooses a quantity to produce. 2. All firms make this choice simultaneously. 3. The model is restricted to a one-stage game. Firms choose their quantities only once. 4. All information is public. Recall that in the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. All firms know the market demand curve, and each firm knows the cost structures of the other firms. The essence of the model: each firm takes the other firms' choice of output level as fixed and then sets its own production quantities. Let's walk through an example. Assume all firms face a single market demand curve as follows: Q = 100 - P where P is the single market price and Q is the total quantity of output in the market. For simplicity's sake, let's assume that all firms face the same cost structure as follows:

MC_i = 10 for all firms I Given this market demand curve and cost structure, we want to find the reaction curve for Firm 1. In the Cournot model, we assume Q i is fixed for all firms i not equal to 1. Firm 1's reaction curve will satisfy its profit maximizing condition, MR1 = MC1 . In order to find Firm 1's marginal revenue, we first determine its total revenue, which can be described as follows Total Revenue = P * Q1 = (100 - Q) * Q1 = (100 - (Q1 + Q2 +...+ Qn)) * Q1 = 100 * Q1 - Q1 ^ 2 - (Q2 +...+ Qn)* Q1 The marginal revenue is simply the first derivative of the total revenue with respect to Q 1 (recall that we assume Q i for i not equal to 1 is fixed). The marginal revenue for firm 1 is thus: MR1 = 100 - 2 * Q1 - (Q2 +...+ Qn) Imposing the profit maximizing condition of MR = MC , we conclude that Firm 1's reaction curve is: 100 - 2 * Q1* - (Q2 +...+ Qn) = 10 => Q1* = 45 - (Q2 +...+ Qn)/2 Q 1 * is Firm 1's optimal choice of output for all choices of Q 2 to Q n . We can perform analogous analysis for Firms 2 through n (which are identical to firm 1) to determine their reaction curves. Because the firms are identical and because no firm has a strategic advantage over the others (as in the Stackelberg model), we can safely assume all would output the same quantity. Set Q 1 * = Q 2 * = ... = Q n * . Substituting, we can solve for Q 1 * . Q1* = 45 => Q1* = 90/(1+n) (Q1*)*(n-1)/2 => Q1* ((2 + n 1)/2) = 45

By symmetry, we conclude: Qi* = 90/(1+n) for all firms I In our model of perfect competition, we know that the total market output Q = 90 , the zero profit quantity. In the n firm case, Q is simply the sum of all Q i * . Because all Q i * are equal due to symmetry: Q = n * 90/(1+n) As n gets larger, Q gets closer to 90, the perfect competition output. The limit of Q as n approaches infinity is 90 as expected. Extending the Cournot model to the n firm case gives us some confidence in our model of perfect competition. As the number of firms grow, the total market quantity supplied approaches the socially optimal quantity.