Monopolistic competition, oligopoly, duopoly and an introduction to game theory

1. Monopolistic competition: meaning

Monopolistic competition is a market with many sellers of differentiated products that are close but not perfect substitutes. The theory was developed by E.H. Chamberlin in The Theory of Monopolistic Competition (1933); Joan Robinson’s The Economics of Imperfect Competition (1933) dealt with the same problem. Most consumer markets in India — soaps, toothpaste, restaurants, clothing, salons — are of this kind.

2. Features

1. Large number of sellers, each with a small share; each acts independently.
2. Product differentiation by brand, quality, design, packaging, location or service. Each seller has a little monopoly over his own brand.
3. Free entry and exit.
4. Selling costs: advertising and sales promotion are essential to differentiate the product and shift demand.
5. Downward-sloping, fairly elastic demand curve: a price rise loses some, not all, customers.
6. Product groups instead of an industry (Chamberlin’s term).
7. Non-price competition is important.

3. Price and output under monopolistic competition

Short run. Each firm behaves like a small monopolist. It produces where MR = MC and charges the price read from its demand (AR) curve. If AR exceeds AC it earns supernormal profit; it may also earn normal profit or bear a loss.

Long run. Supernormal profit attracts new firms producing close substitutes. Each existing firm loses some customers: its demand curve shifts to the left and becomes more elastic. Entry continues until the demand (AR) curve is just tangent to the AC curve. At that point MR = MC and AR = AC: only normal profit is earned. This is Chamberlin’s tangency solution.

The diagram, in words. A gently falling AR, with MR below it. A U-shaped LAC. In the long run AR touches LAC at one point, to the left of the lowest point of LAC. Output is where MR = MC directly below that point.

Excess capacity. Because the tangency is on the falling part of LAC, the firm produces less than the output at minimum average cost. The gap between optimum output and actual output is excess capacity, the social cost of product variety. Prices are higher than under perfect competition, but buyers get choice.

4. Oligopoly: meaning and features

Oligopoly is a market with a few sellers, each large enough for its actions to affect the others. Examples in India: telecom services, cement, automobiles, aviation, soft drinks.

1. Few sellers with a large share each.
2. Interdependence: the defining feature. Each firm must consider how rivals will react before changing price or output.
3. Barriers to entry: large capital, economies of scale, patents, brand loyalty, licences.
4. Homogeneous products (pure oligopoly: cement, steel) or differentiated products (differentiated oligopoly: cars, mobile phones).
5. Heavy advertising and selling costs: Baumol remarked that under oligopoly advertising can become a life-and-death matter.
6. Indeterminate demand curve: the firm cannot know its demand curve because it depends on rivals’ reactions.
7. Price rigidity: prices tend to stay stable because firms fear a price war.
8. Tendency to collude (cartels, price leadership) and group behaviour.

Kinked demand curve. Paul Sweezy (1939) explained price rigidity: if a firm raises price, rivals do not follow and it loses many customers (demand elastic above the current price); if it cuts price, rivals follow and it gains few (demand inelastic below it). The demand curve has a kink at the current price, and the MR curve has a gap below the kink. MC can move within that gap without changing the profit-maximising price.

5. Duopoly: features

Duopoly is the special case of oligopoly with exactly two sellers.

• Two firms producing identical or close-substitute products.
• Each firm’s price and output depend directly on the other’s.
• Entry barred, so the two can keep supernormal profit.
• Possible outcomes: competition (price war), collusion (acting as joint monopolists), or leadership by one.
• Classical models: Cournot (1838) — each firm chooses its output assuming the rival’s output stays fixed; the equilibrium has each producing one-third of the competitive output. Bertrand (1883) — each firm chooses its price assuming the rival’s price stays fixed; with identical products, price is driven down to marginal cost.
• Examples: commercial aircraft (Boeing and Airbus) is the usual one.

6. Game theory: introduction

Game theory studies strategic decisions, where each player’s best choice depends on what others choose. It was founded by John von Neumann and Oskar Morgenstern in Theory of Games and Economic Behavior (1944). John Nash introduced the equilibrium concept named after him (1950). It is the natural tool for oligopoly, where interdependence is the central fact.

Elements of a game:

• Players: the decision-makers (firms).
• Strategies: the courses of action open to each (high price or low price; advertise or not).
• Payoffs: the outcome (profit) for each player from each combination of strategies, set out in a payoff matrix.
• Rules and information: whether moves are simultaneous or sequential, whether the game is played once or repeated.

Types: zero-sum (one player’s gain is the other’s loss) and non-zero-sum (both can gain or lose); cooperative and non-cooperative; one-shot and repeated.

Analysis: dominant strategy and Nash equilibrium. A dominant strategy is one that is best for a player whatever the rival does. A Nash equilibrium is a pair of strategies from which neither player can gain by changing his own choice, given the other’s. The maximin rule (choose the strategy whose worst outcome is best) is used by a cautious player.

7. Worked example: the pricing game (prisoner’s dilemma)

Two firms, A and B, each choose a high or low price. Profits (Rs. crore) are shown as (A, B):

• If B charges high, A earns 10 with high and 15 with low: low is better.
• If B charges low, A earns 2 with high and 5 with low: low is better.
• So low price is A’s dominant strategy, and by symmetry B’s.
• Nash equilibrium: both charge low, earning (5, 5).

Both would be better off at (10, 10) by charging high, but neither can trust the other to keep to it. This is the prisoner’s dilemma (named after the story of two suspects, each of whom does better by confessing). It explains price wars among oligopolists, why cartels are unstable, and why repeated games (where cheating can be punished later) make cooperation more likely.

How this is examined

February 2025: “What is monopolistic market? Explain how price and output are determined in it” (10 marks). January 2026: “Features of duopoly market” or “Features of oligopoly” (6 marks). August 2024: “Game theory” (6 marks). For the game theory note, give the founders, the elements, Nash equilibrium and a 2 × 2 payoff matrix with its solution; the matrix is what distinguishes a good answer.