Workshop 9

(Short-run Profit Maximisation)

Monopolistic Competition and Oligopoly

1. From the list of points below select those which distinguish a monopolistically competitive
industry from a perfectly competitive industry.
(a) There are no barriers to the entry of new firms into the market. ..................................Yes/No
(b) Firms in the industry produce differentiated products. ................................................Yes/No
(c) The industry is characterised by a mass of sellers, each with a small market share. ....Yes/No
(d) A downward sloping demand curve means the firm has some control over the product's
price. .............................................................................................................................Yes/No
(e) In the long run only normal profits will be earned........................................................Yes/No
(f) Advertising plays a key role in bringing the product to the attention of the consumer.Yes/No

2. Following a rapid growth in the demand for home-delivered fast foods, Pukka Pizza is now
earning substantial supernormal profits on its dial-a-pizza business. As a result of this success, a
number of other local restaurants and fast-food diners are diversifying into the home-delivery
market.

(a) What will be the likely effect on the position and elasticity of Pukka Pizza’s demand curve
from this increased competition?
..............................................................................................

(b) How will this depend on the type of food that the new competitors are supplying?

.................................................................................................................................................

.................................................................................................................................................

(c) At what point will firms stop entering the market? .................................................................

.................................................................................................................................................

.................................................................................................................................................
3. The following diagram illustrates a firm under monopolistic competition.

I
II

P6
Price

P5
P4
P3
P2

P1

III
IV
0 Q1 Q2 Q3 Q4 Q5
Quantity
(a) Label the curves.
Curve I .................................................... Curve II ..........................................................
Curve III .................................................. Curve IV.........................................................

(b) What are the profit maximising output and price? ..................................................................

(c) On the diagram, shade in the amount of profit made at the maximum-profit output.

4. The following diagram represents Pukka Pizza’s long-run equilibrium position.

I II
Costs, revenue (£)

8
7
6

III
IV
0 1500 2650 3000
Quantity

(a) What is the long-run equilibrium price? (Tick) £4 … £6 … £7 … £8 …

(b) What is the long-run equilibrium quantity? (Tick) 1500 … 2650 … 3000 …

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5. Which of the following are characteristics of oligopoly?
(a) There are just a few firms that dominate the industry. ...............................................Yes / No
(b) There are few if any barriers to the entry of new firms into the industry. ..................Yes / No
(c) The firms face downward sloping demand curves. ....................................................Yes / No
(d) There is little point in advertising because there are so few firms. ............................Yes / No
(e) Oligopolists tend to take into account the actions and reactions of other firms. .......Yes / No

6. Assume that there are six firms in a country's carpet manufacturing industry and that they
collude to restrict output, thereby maintaining a high price. Under which of the following
circumstances is collusion likely to break down?
(a) The government imposes higher duties on imported carpets. .....................................Yes / No
(b) Several new chains of discount carpet retailers enter the market ...............................Yes / No
(c) One of the firms develops a new cost-saving technique of producing carpets. ..........Yes / No
(d) Three of the smaller manufacturers merge. ................................................................Yes / No
(e) One of the firms becomes dominant in the industry. ..................................................Yes / No
(f) The demand for carpets falls. ......................................................................................Yes / No
(g) Legislation is passed preventing the exchange of information by producers on
costs, sales and product development. ........................................................................Yes / No

7. Which of the following are examples of tacit collusion?

(a) Price leadership by a dominant firm ...........................................................................Yes / No
(b) Agreements 'behind closed doors' ...............................................................................Yes / No
(c) Discounts to retailers .................................................................................................Yes / No
(d) Setting prices at a well-known benchmark .................................................................Yes / No
(e) Increased product differentiation within the industry .................................................Yes / No
(f) Price leadership by a barometric firm.........................................................................Yes / No

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8. The following diagrams illustrate an industry under oligopoly consisting of 10 equal-sized firms
and a particular firm in that industry. Each of the firms produces an identical product.
£ £
40
(a) Assuming that the firms formMCa cartel, what 40price will the cartel choose MC
35 if it wishes to maximise overall profits for the
35 cartel? ...........................
30 30

25 25
(b) What total output must the cartel produce in order to maintain this price? ...........................
20 20
(c) To what output will an individual firm be restricted if this price is to be maintained AR
15 15
(assume all firms are permitted to produce the same level of output)?
10 10 ...........................
AR MR
(d) If the other firms stick to this output, how much would an individual firm be tempted to
5 5
produce if it wished MR
to maximise its own profit at the agreed price?
0 0 ...........................
(e) 0 If it50
undercut
100 the cartel
150 price,
200 what
250 price
300 and output
350 Q 0 would
5 maximise
10 15 20 25 30 35
Q
its profit (assuming that
The Industry
the other members did not retaliate? ...........................
An individual firm

(a) Assuming that the firms form a cartel, what price will the cartel choose if it wishes to
maximise overall profits for the cartel?
....................................................................................

(b) What total output must the cartel produce in order to maintain this price?

(c) To what output will an individual firm be restricted if this price is to be maintained
(assume all firms are permitted to produce the same level of output)?
...................................................
(d) If the other firms stick to this output, how much would an individual firm be tempted to
produce if it wished to maximise its own profit at the agreed price?
.......................................
(e) If it undercut the cartel price, what price and output would maximise its profit (assuming
that the other members did not retaliate?
.................................................................................................................................................

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9. Under non-collusive oligopoly, firms seeking to maximise profits must make assumptions about
their rivals.
(a) In the Cournot model firms make assumptions about their rivals’ choice of price / output.
(b) Under the Bertrand model firms make assumptions about their rivals’ choice of price /
output.
(c) The figure opposite shows the market
demand (DM) for a product. MCA is £
the marginal cost curve facing Firm A,
which operates in the market. Mark MCA
the profit-maximising output and price
level that woud be set by Firm A if it
saw itself as a monopolist (hint: you
will need to add the marginal revenue
curve).
(d) Now suppose that Firm A is aware of a
competing firm (Firm B) in the market
and assume that Firm A expects Firm
B to supply the quantity OB regardless
of price. Add to the diagram Firm A’s DM
demand curve if Firm B does indeed O Q
B
supply the quantity OB.
(e) Mark Firm A’s profit-maximising
level of output and price.
(f) How does this price compare with the monopoly price?

(g) How does this price compare with the marginal cost?

(h) Is this an example of a Cournot or Betrand equilibrium?

(i) If a third firm entered the market and produced a similar quantity to that of Firm B what
would happen to market price? What are the implications of this?

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10. The table below shows the annual profits of two paint manufacturers. At present they both
charge £15.00 per litre for gloss paint. Their annual profits are shown in Box A. The other boxes
show the effects on their profits of one or the other, or both firms reducing their price to £12.00.

Durashine’s price
£15.00 £12.00
A C
£15.00 £2 million for Supasheen
£6 million each
£8 million for Durashine
Supasheen’s
price B D
£9 million for Supasheen
£12.00 £4 million each
£3 million for Durashine

(a) Which of the two prices should Durashine charge if it is pursuing

(i) a maximax strategy? ............................................................................... £15.00/£12.00
(ii) a maximin strategy? ................................................................................ £15.00/£12.00
(b) Which of the two prices should Supasheen charge if it is pursuing
(i) a maximax strategy? ............................................................................... £15.00/£12.00
(ii) a maximin strategy? ................................................................................ £15.00/£12.00
(c) Why is this known as a dominant strategy game?

..........................................................................................................................................
(d) Assume now that the ‘game’ between Supasheen and Durashine has been played for some
time with the result that they both learn a ‘lesson’ from it. What are they likely to do?
..........................................................................................................................................

Durashine now faces competition from firms other than Supasheen. It thus decides to consider
some alternative strategies to adopt. It examines four options. The first is to introduce a 10 per
cent price cut. The second is to introduce a new brand of high gloss durable emulsion paint. The
third is to launch a new marketing campaign. The fourth is to introduce no change other than
increasing its prices in line with inflation. It estimates how much profit (in £m) each strategy (1–
4) will bring depending on how its rivals react. It considers the effects of six possible reactions
(a–f).

Other firms' responses

a b c d e f
Strategies 1 0 1 3 0 2 3
2 –2 5 –2 3 4 6
for
3 –4 2 –1 0 1 8
Durashine 4 2 3 –1 4 3 7

(e) Which of the four policies should it adopt if it is pursuing:

(i) A maximax strategy? ..................................................................................... 1 / 2 / 3 / 4
(ii) A maximin strategy? ...................................................................................... 1 / 2 / 3 / 4
(f) Which of the four policies might be the best compromise? .................................. 1 / 2 / 3 / 4

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11. A firm operating under oligopoly is currently selling 4 units per day at a price of £40. By
conducting extensive market research its chief economist estimates that, if it raises its price, its
rivals will not follow suit and that, as a result, it will face an average revenue curve given by
P = 50 – 5Q/2 (where P = AR)
On the other hand, if it reduces its price, its rivals will be forced to reduce theirs too. Under
these circumstances its average revenue curve will be given by
P = 60 – 5Q (where P = AR)
(a) What will be the equation for the firm's demand curve if the firm raises its price?
..........................................................................................................................................
(b) What will be the equation for the firm's demand curve if the firm reduces its price?
..........................................................................................................................................
(c) How much will be demanded at the following prices?
£50 ............................................................... £45 .............................................................
£40 ............................................................... £30 .............................................................
£20 ............................................................... £10 .............................................................

60

50
Revenue and costs (£)

40

30

20

10

0
0 1 2 3 4 5 6 7 8
Quantity

(d) Plot the two demand curves on the above diagram, marking in bold the portion of each that
is relevant to the firm.
(e) Plot two marginal revenue curves corresponding to each of the demand curves. (Remember
that the MR curve lies midway between the AR curve and the vertical axis.) Mark in bold
the portion of each MR curve that is relevant to the firm.

(f) Over what range of values can marginal cost vary without affecting the profit-maximising
price of £40?
............................................................................................................................