MBA 681 Economics for Strategic Decisions Prepared by Yun Wang 1. How does firm maximize profit. 2. Poduction decision in the perfect competitive market. 3. Production decision in monopolistic competitive market. 4. Production decision in oligopoly. 5. Production decision in monoply. 6. Two special models in oligopoly market. 1. How a Firm Maximizes Profit: All firms try to maximize profits based on the following equation: Profit = Total Revenue − Total Cost The rules we have just developed for profit maximization are: 1. The profit-maximizing level of output is where the difference between total revenue and total cost is greatest, and 2. The profit-maximizing level of output is also where MR = MC. Notice: All of these rules do not require the assumption of market type; they are true for all firms with different market structures (perfect competition, monopolistic competition, oligopoly, monopoly)! The Four Market Structures:Structures Market Structure Characteristic Perfect Competition Monopolistic Competition Oligopoly Monopoly Type of product Identical Differentiated Identical or differentiated Unique Ease of entry High High Low Entry blocked Examples of industries  Growing wheat  Poultry farming  Clothing stores  Restaurants  Manufacturing computers  Manufacturing automobiles  First-class mail delivery  Providing tap water 2. Profit Determination in Perfect Competitive Market: A firm maximizes profit at the level of output at which marginal revenue equals marginal cost. The difference between price and average total cost equals profit per unit of output. Total profit equals profit per unit of output, times the amount of output: the area of the green rectangle on the graph. In the graph on the left, price never exceeds average cost, so the firm could not possibly make a profit. The best this firm can do is to break even, obtaining no profit but incurring no loss. The MC = MR rule leads us to this optimal level of production. The situation is even worse for this firm; not only can it not make a profit, price is always lower than average total cost, so it must make a loss. It makes the smallest loss possible by again following the MC = MR rule. No other level of output allows the firm’s loss to be so small. Identifying Whether a Firm Can Make a Profit Once we have determined the quantity where MC = MR, we can immediately know whether the firm is making a profit, breaking even, or making a loss. At that quantity, • If P > ATC, the firm is making a profit • If P = ATC, the firm is breaking even • If P < ATC, the firm is making a loss Even better: these statements hold true at every level of output. However, if the price is too low, i.e. below the minimum point of AVC, the firm will produce nothing at all. The quantity supplied is zero below this point. 3. Profit Determination in Monopolistic Competitive Market: (1 of 3) In the short run, a monopol.

1. MBA 681 Economics for Strategic Decisions
Prepared by Yun Wang
1. How does firm maximize profit.
2. Poduction decision in the perfect competitive market.
3. Production decision in monopolistic competitive market.
4. Production decision in oligopoly.
5. Production decision in monoply.
6. Two special models in oligopoly market.
1. How a Firm Maximizes Profit:
All firms try to maximize profits based on the following
equation:
Profit = Total Revenue − Total Cost
The rules we have just developed for profit maximization are:
1. The profit-maximizing level of output is where the difference
between total revenue and total
cost is greatest, and
2. The profit-maximizing level of output is also where MR =
MC.
Notice: All of these rules do not require the assumption of
market type; they are true for all

2. firms with different market structures (perfect competition,
monopolistic competition,
oligopoly, monopoly)!
The Four Market Structures:Structures
Market Structure
Characteristic Perfect Competition
Monopolistic
Competition Oligopoly Monopoly
Type of product Identical Differentiated Identical or
differentiated Unique
Ease of entry High High Low Entry blocked
Examples of
industries
-class mail delivery

3. 2. Profit Determination in Perfect Competitive Market:
A firm maximizes profit at
the level of output at which
marginal revenue equals
marginal cost.
The difference between
price and average total cost
equals profit per unit of
output.
Total profit equals profit per
unit of output, times the
amount of output: the area
of the green rectangle on the
graph.
In the graph on the left, price
never exceeds average cost,
so the firm could not possibly
make a profit.
The best this firm can do is to
break even, obtaining no
profit but incurring no loss.
The MC = MR rule leads us to
this optimal level of
production.
The situation is even worse
for this firm; not only can it

4. not make a profit, price is
always lower than average
total cost, so it must make
a loss.
It makes the smallest loss
possible by again following
the MC = MR rule.
No other level of output
allows the firm’s loss to be
so small.
Identifying Whether a Firm Can Make a Profit
Once we have determined the quantity where MC = MR, we can
immediately know
whether the firm is making a profit, breaking even, or making a
loss. At that quantity,
• If P > ATC, the firm is making a profit
• If P = ATC, the firm is breaking even
• If P < ATC, the firm is making a loss
Even better: these statements hold true at every level of output.
However, if the price is too low, i.e. below the minimum point
of
AVC, the firm will produce nothing at all.
The quantity supplied is zero below this point.

5. 3. Profit Determination in Monopolistic Competitive Market:
(1 of 3)
In the short run, a monopolistic competitive firm might make a
profit or a
loss.
The situation where the firm is making a profit is above.
Notice that there are quantities for which demand (price) is
above ATC;
this is what allows the firm to make a profit.
Now the firm is making a loss.
Notice that there is now no quantity for which demand (price) is
above ATC; this firm must make a (short-run) economic loss, no
matter what quantity it chooses.
In the long run, the firm must break even.
Notice that the ATC curve is just tangent to the demand curve.
The best the firm can do is to produce that quantity.
There is no quantity at which the firm can make a profit; the
ATC
curve is never below the demand curve.

6. In the long run, firms in both perfect competitive market and
monopolistic competitive market make zero profits.
4. Profit Determination in the case of Oligopoly:
D2
D1
MR2
MR1
Price
Quantity0 Q
P
a b
c
d
MC0
MC1
The demand curve for the firms
facing oligopoly situation
changed.
The demand curve is kinked

7. The firms still need:
MR = MC
to maximize their profits.
In the short run, firm will produce
at quatity Q1.
At Q1, the average cost is shown
in the graph, and it is below the
market price P1.
In this case, the oligopoly firm
makes profit in the short run.
In the long run, the profit can be
zero or greater than zero.
5. Profit Determination in the case of Monopoly:
MR = MC
• The demand curve determines price, and
• The average total cost (ATC) curve determines average cost.
Profit is the difference between these (P–ATC), times quantity
(Q).
Since there are barriers to entry, additional firms cannot enter
the market.
• So there is no distinction between the short run and long run

8. for a monopoly.
Then unlike for perfect competition and monopolistic
competition, we expect monopolists
to continue to earn profits in the long run.
Below is the summary chart for the different market structures:
6 Cournot Oligopoly Model
The Cournot model explains how oligopoly firms behave if they
simultaneously choose how much they produce.
Four main assumptions:
1. There are two firms and no others can enter the market
2. The firms have identical costs
3. The firms sell identical products
4. The firms set their quantities simultaneously
Example: Airline market
6 Cournot Model of an Airline Market
Recall the interaction between American Airlines and United
Airlines from Chapter 13.
• In normal-form game, we assumed airlines chose between two
output levels.
• We generalize that example; firms choose any output level.
The Cournot equilibrium (or Nash-Cournot equilibrium) in this

9. model is a set of quantities chosen by firms such that, holding
quantities of other firms constant, no firm can obtain higher
profit
by choosing a different quantity.
6 Cournot Model of an Airline Market
Demand and Cost
The quantity each airline chooses depends on the residual
demand curve it faces and its marginal cost.
Estimated airline market demand:
• p = dollar cost of one-way flight
• Q = total passengers flying one-way on both airlines (in
thousands per quarter)
Assume each airline has cost MC = $147 per passenger
How does the monopoly outcome compare to duopoly (Cournot
with two firms)?
6 Cournot Model of an Airline Market
American Airlines’ choice under monopoly and duopoly.
In the duopoly model, American Airlines faces residual demand.
6 Cournot Model of an Airline Market

10. Residual Demand
In duopoly, if United flies qU passengers, American transports
residual
demand.
• American’s residual demand:
What is American’s best-response, profit-maximizing output if
it
believes United will fly qU passengers?
• American behaves as if it has a monopoly over people who
don’t fly
on United (summarized by residual demand).
• American’s residual inverse demand:
Residual inverse demand function is useful for expressing
revenue
(and MR) in terms of rival’s quantity.
6 Cournot Model of an Airline Market
Residual Demand
Residual inverse demand function is useful for expressing
revenue
(and MR) in terms of rival’s quantity.
• Setting MR=MC yields American’s best-response function:
Given our assumptions, United’s best-response function is
analogous:

11. 6 Cournot Model of an Airline Market
The Equilibrium
The Nash-Cournot equilibrium is the point where best-response
functions intersect: qA = qU = 64
6 Cournot Equilibrium with Two or More Firms
With n firms, total market output is Q = q1 + q2 + … + qn
Firm 1 wants to maximize profit by choosing q1:
• FOC when Firm 1 views the outputs of other firms as fixed:
Firm 1’s best-response function found via MR=MC:
Simultaneously solving for all firms’ best-response functions
yields
Nash-Cournot equilibrium quantities, q1 = q2 = … = qn = q
6 Cournot Equilibrium with Two or More Firms
Linear demand p=a-b(q1+…+qn) and marginal cost m
Equilibrium output q=q1=q2=…=qn is
Equilibrium market output is
Equilibrium price is
( 1)
a m

12. q
n b
( )
( 1)
n a m
Q nq
n b
1
a nm
p
n
6 Cournot Model with Nonidentical Firms
Different Costs
Linear demand p=a-b(q1+…+qn)
Firm 1’s marginal cost is m and Firm 2’s is m+x
The best-response functions are

13. The equilibrium output is
The equilibrium profits are
1 2and 2 2
a m x bqa m bq
q q
b b
1 2
2
and
3 3
a m x a m x
q q
b b
1 2
2
9 9

14. a m x a m x
b b
16 Cournot Model with Nonidentical Firms
Different Products: Intel and AMD
Demands
Each firm’s marginal cost is 40
Best-response functions are
Equilibrium output is
Equilibrium prices per CPU are
197 15
157 0.3 450 6
and
30.2 30.2
I I
A I
q q
q q

15. 7 Bertrand Oligopoly Model
What if, instead of setting quantities, firms set prices and
allowed
consumers to decide how much to buy?
A Bertrand equilibrium (or Nash-Bertrand equilibrium) is a set
of prices such that no firm can obtain a higher profit by
choosing
a different price if the other firms continue to charge these
prices.
The Bertrand equilibrium is different than a quantity-setting
equilibrium in either the Cournot or Stackelberg models.
17 Bertrand Oligopoly Model
Assumptions of the model:
• Firms have identical costs (and constant MC=$5)
• Firms produce identical goods
Conditional on the price charged by Firm 2, p2, Firm 1 wants to
charge slightly less in order to attract customers.
If Firm 1 undercuts its rival’s price, Firm 1 captures entire

16. market
and earns all profit.
Thus, Firm 2 also has incentive to undercut Firm 1’s price.
Bertrand equilibrium price equals marginal cost (as in
competition) because of incentive to undercut.
17 Bertrand Oligopoly Model
Bertrand equilibrium price equals marginal cost (as in
competition) because of incentive to undercut.
7 Nash-Bertrand Equilibrium with Differentiated
Products
In many markets, firms produce differentiated goods.
• Examples: automobiles, stereos, computers, toothpaste
Many economists believe that price-setting models are more
plausible
than quantity-setting models when goods are differentiated.
• One firm can charge a higher price for its differentiated
product
without losing all its sales (e.g. Coke and Pepsi).
If we relax the “identical goods” assumption, the Bertrand
model
predicts that firms set prices above MC.

17. 7 Nash-Bertrand Equilibrium with Differentiated
Products
Example: Cola market
Demand curve of Coke:
• qC = quantity of Coke demanded in tens of millions of cases
• pC = price of 10 cases of Coke
• pP = price of 10 cases of Pepsi
If Coke faces constant MC=m, its profit is
7 Nash-Bertrand Equilibrium with Differentiated
Products
Coke maximizes profit by choosing price conditional on the
price
charged by Pepsi.
• Coke’s best-response function:
Assuming m = $5, Coke’s best-response function is simplified
such that
it can be graphed as a function of Pepsi’s price:
Analogous steps for Pepsi yield Pepsi’s best-response function:
7 Nash-Bertrand Equilibrium with Differentiated
Products

18. Intersection of best-response curves is equilibrium e1.
If Coke’s MC rises, its best-response curve shifts up and results
in new equilibrium e2.