Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 13: Monopolistic Competition and Oligopoly By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives Explain how price and output are determined under monopolistic competition Describe the characteristics of Oligopoly and the Cournot Model Compare several key noncooperative oligopoly models, including Stackelberg and the dominant firm Show how price and output are determined under the cooperative oligopoly model of cartels Copyright © 2015 John Wiley & Sons, Inc All rights reserved Explain how price and output are determined under monopolistic competition 13.1 PRICE AND OUTPUT UNDER MONOPOLISTIC COMPETITION Copyright © 2015 John Wiley & Sons, Inc All rights reserved Price and Output Under Monopolistic Competition Monopolistic competition – a market characterized by: unrestricted entry and exit a large number of independent sellers producing differentiated products Differentiated product – a product that consumers view as different from other similar products Copyright © 2015 John Wiley & Sons, Inc All rights reserved Determination of Market Equilibrium The demand curve facing each firm is downward-sloping but fairly elastic, reflecting a firm’s market power Differs from a monopoly: Firm demand curve is not the market demand Entry into the market is not restricted Firms compete on product differentiation as well as price Long-run equilibrium: attained as a result of firms entering (or leaving) the industry in response to profit incentives Price > MC zero economic profit Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 13.1 – Monopolistic Competition Copyright © 2015 John Wiley & Sons, Inc All rights reserved Monopolistic Competition and Efficiency Excess capacity – the result of firms failing to produce at lowest possible average cost The firm does not operate at the minimum point on the LR average cost curve Total output is wrong from a social perspective due to deadweight loss Deadweight loss is analytically reduced if the interdependence between individual firms’ demand is taken into account Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 13-2 – Alleged Deadweight Loss of Monopolistic Competition Copyright © 2015 John Wiley & Sons, Inc All rights reserved Is Government Intervention Warranted? Three reasons why government intervention is probably not warranted: Any deadweight loss is likely to be small, due to the presence of competing firms and free entry Any possible inefficiency cost must be weighed against the product variety produced and the benefits of such variety to consumers The costs of intervention must be balanced against the potential gain from expanding output Copyright © 2015 John Wiley & Sons, Inc All rights reserved Describe the characteristics of Oligopoly and the Cournot Model 13.2 OLIGOPOLY AND THE COURNOT MODEL Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Other Oligopoly Models The Stackelberg Model – a model of oligopoly in which a leader firm selects its output first, taking the reactions of follower firms into account Dominant Firm Model – a model of oligopoly in which the leader or dominant firm assumes its rivals behave like competitive firms in determining their output Copyright © 2015 John Wiley & Sons, Inc All rights reserved 18 The Stackelberg Model Residual demand curve – a firm’s demand curve based on the assumption that the firm knows how much output rivals will produce for each output the firm may choose Key point: a firm’s conjectures in an oligopoly about how rivals will respond can affect firms’ outputs, profits, and total industry output Which model is better, the Stackelberg model or the Cournot model? It depends upon the particular market under examination Copyright © 2015 John Wiley & Sons, Inc All rights reserved 19 Figure 13.5 - The Stackelberg Model Copyright © 2015 John Wiley & Sons, Inc All rights reserved 20 The Dominant Firm Model The leader assumes its rivals behave like competitive firms in determining their output Also known as “the dominant firm with a competitive fringe” model At any price, the dominant firm can sell an amount equal to the total quantity demanded at that price minus the quantity the fringe firms produce At equilibrium, price > MC for the dominant firm but price = MC for the fringe firm Total output < output for a competitive industry Model is applicable if there are many fringe firms Copyright © 2015 John Wiley & Sons, Inc All rights reserved 21 Figure 13.6 - The Dominant Firm Model Copyright © 2015 John Wiley & Sons, Inc All rights reserved 22 The Elasticity of the Dominant Firm’s Demand Curve ηD = ηM (1/MS) + εSF((1/MS) – 1) where: ηD = elasticity of the dominant firm’s demand ηM = elasticity of the market demand MS = the dominant firm’s market share εSF = elasticity of supply of the fringe firms (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved 23 The Elasticity of the Dominant Firm’s Demand Curve (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved 24 Show how price and output are determined under the cooperative oligopoly model of cartels 13.4 CARTELS AND COLLUSION Copyright © 2015 John Wiley & Sons, Inc All rights reserved 25 Cartels and Collusion Cartel – an agreement among independent producers to coordinate their decisions so each of them will earn monopoly profit Collusion – coordinated decisions among independent producers in an industry Cartels are illegal under antitrust laws in the United States Copyright © 2015 John Wiley & Sons, Inc All rights reserved 26 Cartelization of a Competitive Industry Competitive firms are unable to raise price by restricting output When firms act jointly to limit the amount supplied, price will increase Firms can always make a larger profit by colluding rather then by competing Idealized cartel result: same as if the industry were supplied by a monopoly that controlled the 20 firms Copyright © 2015 John Wiley & Sons, Inc All rights reserved 27 Figure 13.7 – A Cartel Copyright © 2015 John Wiley & Sons, Inc All rights reserved 28 Why Cartels Fail Each firm has a strong incentive to cheat on the cartel agreement Members of the cartel will disagree over appropriate cartel policy regarding pricing, output, allowable market shares, and profit sharing Profits of the cartel members will encourage entry into the industry Copyright © 2015 John Wiley & Sons, Inc All rights reserved 29 Oligopolies and Collusion Firms in an oligopolistic industry can increase their profits by colluding The limited number of firms makes it easier to reach agreements When few firms are involved, it is easier to detect cheaters Factors that inhibit the formation and maintenance of cartels: Incentive to cheat Higher price achieved by collusion prompts entry by new firms It is not necessary for all firms in the industry to participate in the cartel for it to be worthwhile Copyright © 2015 John Wiley & Sons, Inc All rights reserved 30 The Case of OPEC Reasons for Success: The price elasticity of demand for oil is low in the short run The price elasticity of supply of oil from non-OPEC suppliers is low in the short run Oil-importing nations frequently adopted policies that strengthened OPEC’s position In general, the magnitude of any response in consumption and production will be greater the more time consumers and producers are given to respond Copyright © 2015 John Wiley & Sons, Inc All rights reserved 31 Figure 13.8 – OPEC Cartel as a Dominant Firm Copyright © 2015 John Wiley & Sons, Inc All rights reserved 32 ... known as “the dominant firm with a competitive fringe” model At any price, the dominant firm can sell an amount equal to the total quantity demanded at that price minus the quantity the fringe... Oligopoly and the Cournot Model 13. 2 OLIGOPOLY AND THE COURNOT MODEL Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Oligopoly Oligopoly – an industry structure characterized by: ... and the dominant firm Show how price and output are determined under the cooperative oligopoly model of cartels Copyright © 2015 John Wiley & Sons, Inc All rights reserved Explain how price and