Explain how firms set price and quantity in oligopoly and monopolistic competition
The idea
Firms under monopolistic competition and oligopoly face downward-sloping demand, so each maximises profit by producing where marginal revenue equals marginal cost and then charging the price the demand curve allows at that output. For linear demand P = a - bQ, marginal revenue is a - 2bQ. Because MR = P(1 - 1/|E|), the more elastic the demand, the smaller the markup over marginal cost. Under monopolistic competition, entry erodes economic profit in the long run. Oligopolists must anticipate rivals: the kinked demand model explains sticky prices when rivals match cuts but not rises; Cournot firms choosing quantities simultaneously end up between the monopoly and competitive outcomes; a Stackelberg leader moves first and takes the larger share; and a dominant firm sets the price that smaller firms follow.
A practice question
A firm in monopolistic competition maximises short-run profit by producing the output at which:
- marginal revenue equals marginal cost — correct
- price equals marginal costWhy not: Price equal to marginal cost is the perfectly competitive rule; a firm with a downward-sloping demand curve has marginal revenue below price.
- average total cost is at its minimumWhy not: Minimum average cost is where a perfectly competitive firm ends up in the long run, not the profit-maximising rule for a differentiated seller.
Every profit-maximising firm expands output until the last unit adds as much to revenue as to cost. Because the monopolistic competitor faces a downward-sloping demand curve, it then charges the price that curve allows at that output.
A harder one
A monopolistically competitive firm faces demand P = 100 - 2Q and a constant marginal cost of 16. Its profit-maximising output and price are:
- Q = 42 and P = 16Why not: Setting price equal to marginal cost gives the competitive outcome; the firm instead sets marginal revenue, 100 - 4Q, equal to marginal cost.
- Q = 21 and P = 16Why not: The output is right, but the price has been read from the marginal cost line rather than from the demand curve at that output.
- Q = 21 and P = 58 — correct
Marginal revenue for linear demand has twice the slope: MR = 100 - 4Q. Setting 100 - 4Q = 16 gives Q = 21, and the demand curve then gives P = 100 - 2(21) = 58.
The hardest tier
Two identical Cournot duopolists face market demand P = 130 - Q, where Q is combined output, and each has a constant marginal cost of 10. The equilibrium market price is closest to:
- 70Why not: This is the joint-monopoly price: combined output of 60 where industry MR equals MC. Cournot rivals do not restrict output that far.
- 50 — correct
- 10Why not: A price equal to marginal cost is the competitive or Bertrand outcome, not the result of rivals setting quantities.
Each firm's best response is q = (120 - q_rival)/2. With symmetric firms q = 120/3 = 40 each, so combined output is 80 and P = 130 - 80 = 50, between the monopoly price of 70 and the competitive price of 10.
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