Unit 3: Supply Decision in Imperfect Competition

1. Monopolistic Market: Price & Output Determination

Monopolistic competition is a market structure characterized by many firms selling differentiated products.

Short-run Equilibrium

In the short run, a firm under monopolistic competition behaves like a monopoly. It produces at a level where Marginal Revenue (MR) = Marginal Cost (MC), provided price is greater than Average Variable Cost (AVC).

Long-run Equilibrium

Due to the free entry and exit of firms, any supernormal profits are eroded in the long run. Firms only earn normal profits where the demand curve (AR) is tangent to the Long-run Average Cost (LAC) curve.

2. Collusive vs Non-Collusive Oligopoly

Oligopoly is a market with a few large sellers. The key feature is interdependence between firms.

• Non-Collusive Oligopoly: Firms compete with each other and act independently based on their assumptions about rivals' reactions.
• Collusive Oligopoly: Firms cooperate to reduce competition, often forming a cartel to maximize joint profits.

3. Cournot Model

The Cournot model assumes that each firm chooses its quantity produced, assuming the rival's output remains constant.

Equilibrium Point: The intersection of the Reaction Curves of the two firms.

In a duopoly (two firms), each firm ends up producing 1/3 of the total market capacity, leading to a total output of 2/3 of the competitive level.

4. Bertrand Model

The Bertrand model assumes that firms compete on price rather than quantity.

• Firms assume the rival will keep its price constant.
• If products are homogeneous, a price war occurs until Price = MC.
• Outcome: Even with only two firms, the market reaches a competitive equilibrium result.

5. Stackelberg's Model

This is a "Leader-Follower" model. One firm (the leader) moves first and chooses its output, anticipating how the follower will respond.

• The Leader earns higher profits than in the Cournot model.
• The Follower earns lower profits than in the Cournot model.

6. Kinked Demand Curve

Developed by Paul Sweezy, this explains price rigidity in oligopolies.

• Assumption: If a firm increases its price, rivals will not follow. If it decreases its price, rivals will follow immediately.
• This creates a "kink" in the demand curve at the prevailing price.
• The MR curve becomes discontinuous, meaning MC can shift within a range without changing the equilibrium price or output.

7. Introduction to Game Theory (Duopoly)

Game theory provides a mathematical framework for analyzing strategic interactions.

Two-Person Zero-Sum Game

A game where the gain of one player is exactly equal to the loss of the other. The sum of gains and losses is zero.