Monopolistic Competition/Oligopoly
1. What are the key characteristics of a monopolistically competitive market? Some experts
have argued that too many brands of breakfast cereal are on the market. Give an argument to
support this view, and an argument against this view. (1.5 points)
2. Explain the meaning of a Nash equilibrium when firms are competing with respect to price,
and give an example. Why is the equilibrium stable? Why don’t the firms raise prices to the
level that would maximize joint profits? (1.5 points)
3. “Because firms in any industry can always make greater profits by colluding, there is an
inevitable tendency for competitive industries to become cartels over time”. Applying the
Prisoner’s dilemma, briefly discuss the validity of this statement (1 point)
4. Suppose that two identical firms, Firm 1 and Firm 2, produce widgets and that they are the
only firms in the market. Their total costs are given by Ci = 30Qi, which means MC1 = 30;
MC2 = 30. The two firms choose their output levels simultaneously, and market demand is
given by P = 150 – Q, where Q = Q1 + Q2. The marginal revenue schedules for each firm are
as follows:
MR1 = 150 – 2Q1 – Q2
MR2 = 150 – 2Q2 – Q1
a) Determine each firm’s reaction function and find the Cournot-Nash equilibrium. Determine
the output, price and profit of producing widgets for each firm. (2 points)
b) Suppose that the two firms collude and form a cartel. What will be the resulting output, price
and profit for each firm? [Hint: market marginal revenue is 150 – 2Q, because total revenue
= P*Q = (150-Q)*Q] (1 point)
c) Suppose Firm 1 were the only firm in the market. How would the market output and Firm 1’s
profit differ from that found in your answer to 4b) above? (1 point)
5. Suppose that the airline industry consisted of only two firms: American and Texas Air Corp.
Let the two firms have identical cost functions, C(Q) = 40Q; MC = 40. Assume the demand
curve for the industry is given by P = 100 – Q and that each firm expects the other to behave
as a Cournot competitor. The marginal revenue schedules for each firm are as follows:
MRA = 100 – 2QA – QT
MRT = 100 – 2QT – QA
a) Calculate the Cournot-Nash equilibrium for each firm, assuming that the each firm
choose the output level that maximizes profits taking its rival’s output as given. What are
the profits for each firm? (1 point)
b) Suppose that Texas Air’s costs dropped to AC = MC = 25, and American costs remained
at AC = MC = 40. Work out the equilibrium quantity, price and profit for each firm. (1
point)
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