Exercises on Market Power

Monopoly and Oligopoly

Recap on monopoly

ˆ Monopolist: one single firm active in a market that has pricing power (price-maker). The
monopolist recognizes that it can affect prices through its choice of quantity.

ˆ Profit maximization in a monopoly: The monopolist chooses the optimal quantity Q∗ to

maximize its profit:

max Π = R (Q) − C (Q)

Q
= P (Q) Q − C (Q)

ˆ Optimal output rule: The profit maximizing quantity Q∗ is determined by

M R(Q∗ ) = M C(Q∗ )
⇔ P ′ (Q) Q + P (Q) = M C (Q)

(Note: M R(Q) < P ′ (Q) for all Q > 0)

ˆ Price elasticity of demand (at a given price P): the percentage change in quantity demanded
in response to a 1 percentage increase in price.

p dQ pD′ (p)
ε(p) ≡ − =−
Q dp D(p)

⇒ The greater ε, the more elastic demand (i.e., the more sensitive consumers are to price).

ˆ The markup rule: A measure of the monopolist’s market power.

P − MC 1
=
P ε
It indicates that the more elastic demand is, the smaller the gap between P and M C will be.

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Recap on Oligopolies
ˆ Best-response function (or curve): specifies the best action to be taken (for example in terms
of setting a quantity or a price) as a function of the rivals’ actions.
ˆ Cournot game: A simultaneous game in which two firms strategically choose their quantity
level to maximize their profit.
ˆ Cournot-Nash equilibrium (in a duopoly): A pair (q1∗ , q2∗ ) of quantities such that each quantity
is a profit-maximizing choice, given the quantity chosen by the other firm. In other words, to
qualify as an equilibrium, the firms’ choices must be profit-maximizing against each other.
ˆ Steps to find the Cournot-Nash equilibrium in a duopoly:
Case 1: Symmetric firms, i.e. same market demand and same costs.
1) Take the perspective of one firm, say firm 1, and compute its best-response function q1∗ (q2 ) ⇒
to find the best response function, simply set M R1 = M C.
2) Since firms are symmetric, firm 2 has a symmetric best-response function q2∗ (q1 ) – no need to
do all calculations again.
3) Solve the system of best-response curves to find the equilibrium quantity of each firm q1∗ and
q2∗ .
Case 2: Asymmetric firms, i.e., same market demand but different costs.
1) Compute the best response functions for each firm ⇒ to find the best response function of each
firm i, set M Ri = M Ci for each firm.
2) Solve the system of best responses as in Case 1.

ˆ Cartel: a group of firms that coordinate production decisions (and act as a monopoly).
ˆ Bertrand duopoly: A simultaneous game in which two firms strategically choose their prices
to maximize profit.
ˆ Bertrand-Nash equilibrium:
CASE 1: If all firms have identical costs (same marginal costs) the equilibrium is given by
p∗1 = p∗2 = M C.
CASE 2: If firms have different marginal costs, then the firm with the lowest marginal cost
manages to price the other out of the market. It will be enough to set a price slightly lower than
the marginal cost of the opponent.
ˆ Bertrand ‘Paradox’: How is it possible to achieve a perfectly competitive price (when firms
have same MC) if there are only two firms with market power? Think of Bertrand model as a
model of competitive bidding. This is typical of markets where firms compete by bidding for
business (i.e., bidding on a project). For example, consider the market to provide telephone
service to a national government. The firms have to submit fixed prices to the government and
then the government chooses whom to purchase the service. Even if firms agree to collude and
submit high bids, each has an incentive to cheat and submit a low bid!
ˆ Cournot vs. Bertrand: Which model is more appropriate to describe reality? It depends!
– Cournot model is a good description for industries in which firms have to choose a capacity
level (constraint). That is, when firms have to make fixed production plans, so that it is hard
to adjust output levels once they have planned them. E.g.: how large should a supermarket be?
Gas stations, hotel chains (it takes long time to build additional rooms...).
– Bertrand model is a good description when firms compete by ‘bidding’ for business.
Note: In some industries, firms may mix competition à la Cournot and à la Bertrand. E.g.:
airline companies tend to compete on price (à la Bertrand) if full capacity is not reached (because
they have the flexibility to quickly adjust the quantity once they change the price). But at full
capacity, they lose such flexibility and they will play à la Cournot.

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Exercise 1 Mark-up rule
1 2
A monopoly with a cost function C (q) = 2q + 4 faces a demand for its product given by D(p) = p2
.
1. What is the monopoly price pm ?

2. What is the elasticity of demand at the monopoly price?

m −M C
3. What is the mark-up ( p pm ) of the monopolist? How does it relate to the elasticity of demand?

Exercise 2 Monopoly and externalities

A monopolistic firm faces a (inverse) demand curve given by p = 16 − q, where q ∈ [0, 16]. The cost
function consists of the rent paid for the office space, which is equal to 1, and of variable costs worth
q2.

1. What is the monopoly price?

2. The rent increases by 10%. How should the monopolist react?

Let’s assume that production is polluting. A production level q generates a nuisance m(q) = αq 2 for
consumers (α > 0). Accordingly, the governments sets a unit (Pigou) tax t.
3. What is the price set by the monopolist as a function of t?

4. Derive the consumer surplus (taking into account the nuisance from the pollution m(q))? How
does this surplus vary with t. Comment.

5. What is the value of t∗ such that the total surplus (consumer surplus-disutility from pollu-
tion+fiscal proceeds+monopoly profit, ie, CS(q) − m(q) + tq + π(q)) is maximum. How does
t∗ vary with α ? Comment.

Exercise 3 Privatization of a monopoly

The state is the only shareholder of firm XYZ which has a monopoly on the market for GLUB. The
total demand for GLUB is D(p) = 600 − p. The cost for producing quantity q are C(q) = q 2 /4.

1. If the goal of the government is to obtain maximal total surplus, at what price should the firm
sell the GLUB? Calculate the total surplus on this market.

2. To cover some of its deficit, the state decides to privatize XYZ and to sell the firm to a private
investor without opening the market to competition. What will be the price of GLUB set by
XYZ after privatization? What is the new total surplus? Compare with the previous question.

3. What is the maximal price at which the government can sell XYZ? Do the revenue from the sale
cover the loss in the surplus?

4. Some time after privatization, it is decided to open the market to competition. The state requires
entrants to acquire a license which costs 160.000 Euros. The technology of GLUB production is
standard and the cost structure of entrants is the same as that of XYZ. Does the opening of the
market in these conditions affect the profits of XYZ?

5. Competition authority declares that the license cost is too high and that it prevents competition.
It sets the license price to 40.000 Euros. What is the long-run equilibrium price?

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Exercise 4 Cross licensing as a collusion mechanism

Consider an industry composed of 2 firms (Firm 1 and Firm 2) that compete à la Cournot. The demand
is given p = 100 − q1 − q2 . Each firm has a marginal cost of production of 10 euros per unit.

1. What are the quantities produced by each firm at the Cournot equilibrium?

2. What are the quantities produced by each firm if the two firms collude and maximize their joint
profit.

3. Colluding is forbidden but suppose that the firms 1 and 2 sign the following contract. Firm 1
commits to pay T euros to firm 2, per unit produced by firm 1. Symmetrically, firm 2 commits
to pay T euros to firm 1, per unit produced by firm 2. The two firms justify these payments
vis-à-vis the competition authority by the existence of cross-licenses that require the payment of
“royalties” per each unit produced. That is to say, each firm has a patent on a product that is
essential in the production process of the other (Apple may need to use some Microsoft software
and vice-versa).
Calculate the Cournot equilibrium induced by the amount T . Is there a value of T for which the
outcome corresponds to collusion?

Exercise 5 Quantity competition

Consider a duopolistic market where the inverse demand function is p(Q) = 4 − Q where Q is the total
production. The total cost functions are:

Firm 1: C1 (q1 ) = q1
Firm 2: C2 (q2 ) = 21 q22

where q1 and q2 is the production of firms 1 and 2. We have Q = q1 + q2 .

Determine the Cournot equilibrium and calculate the profit obtained by each firm.

Exercise 6 Innovation and oligopolistic competition

Two firms compete in quantities. The total demand in this market is D(p) = 10 − p. The marginal
production costs are constant and equal to 4 for each firm (so that C(q) = 4q for each firm).

1. What is the Cournot equilibrium in this market? State clearly what are: the best response func-
tions, the produced quantities in equilibrium, the market price, and the profit of each company.

2. Firm 1 modernizes its machine park and its marginal cost falls from 4 to 1. What is the Cournot
equilibrium in this new situation? Give the quantities, prices and profits of firms in equilibrium.

3. What happens when both firms modernize and manage to lower their marginal costs to 1? Give
the quantities, prices and profits of firms in the new Cournot equilibrium.

In reality this modernization requires firms to sink a cost F to lower its marginal cost from 4 to
1. We can think of a two period game here:

ˆ Period 1: Each firm decides whether to modernize or not and whether to pay or not the
investment cost F . These decisions are made simultaneously.
ˆ Period 2: The two firms compete in quantities knowing what were the investment decisions
taken by both firms in the first period.

4. Write down the matrix of the simultaneous game played at period 1

5. What are the values of F for which the two firms prefer not to invest no matter what their
opponents do?

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 6. For what values of the fixed cost F there exists an equilibrium where both firms invest?

7. Solve the game for F = 10.

8. Assume still that F = 10. If firm 1 now takes the modernization decision before firm 2 (so now
in period 1 the game is a sequential), what is the outcome of the game?
Finally, suppose that Firm 2 announces in the press before the game takes place that it will
modernise its machine park no matter what Firm 1 does.

9. Is this announcement credible? How does it modify the outcome of the game.

Exercise 7 Entry in Bertrand duopoly

Consider a market where the demand is given by D(p) = 10 − 2p. There are two potential firms with
cost function C(q) = q that have an opportunity to enter this market. If both firms enter, they compete
à la Bertrand. If only one firm enters, the entrant is a monopolist. Entry involves a cost of 5.

1. Suppose first that both firms take their entry decisions simultaneously. Represent this game as a
table. What is/are the Nash equilibrium/a/?

2. Suppose now that Firm 1 is deciding first whether to enter, while Firm 2 can enter only after
observing Firm 1’s entry decision. What is the outcome of the game?

Exercise 8 Price competition

Two firms produce two differentiated goods.

Firm 1 produces the good 1 and its function of total cost is, for a production of q1 , C1 (q1 ) = cq1 .
Firm 2 produces the good 2 and its function of total cost is, for a production of y2 , C2 (q2 ) = 21 (q2 )2 .
The demand functions for each of the 2 goods are given by:

D1 (p1 , p2 ) = 10 − 2p1 + p2
D2 (p1 , p2 ) = 12 − 2p2 + p1

Each of firms determines its price on its own.

1. Determine and represent graphically the reaction functions R1 (p2 ) and R2 (p1 )

2. Determine the price and the profits in equilibrium. How do these prices and profits evolve if the
marginal cost c of firm 1 increases?

Exercise 9 Homogeneous products

There are two bakeries in the neighborhood that produce identical products. The inverse demand
function in the market for pies is p = 100 − Q. The fixed costs of production are identical for each of
the two bakeries and are at 500 euros, the variable costs are 2 euros per pie.

1. If the bakeries are in price competition, what will be the prices and quantities produced at the
equilibrium? What are the profits of each bakery?

2. If they are in quantity competition, what will be the prices and quantities produced in the
equilibrium? What are the profits of each bakery?

3. If they decide to form a cartel, what are the prices and quantities produced in the equilibrium?
What are the profits of each bakery?