MicroEconomics theory and application 12th by browning an zupan chapter 13

 Show how price and output are determined under the cooperative oligopoly model of cartels... Monopolistic Competition and Efficiency Excess capacity – the result of firms failing to pr

MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

12 th Edition, Copyright 2015

Chapter 13: Monopolistic Competition and Oligopoly

Prepared by Dr Della Lee Sue, Marist College

 Show how price and output are determined under the

cooperative oligopoly model of cartels

13.1 PRICE AND OUTPUT UNDER

MONOPOLISTIC COMPETITION

Explain how price and output are determined under monopolistic

competition.

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

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

Figure 13.1 – Monopolistic Competition

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

Figure 13-2 – Alleged Deadweight Loss

of Monopolistic Competition

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

13.2 OLIGOPOLY AND THE COURNOT MODEL

Describe the characteristics of Oligopoly and the Cournot Model.

Oligopoly – an industry structure characterized by:

 a few firms producing all or most of the output of some good that may or many not be differentiated

 mutual interdependence: a firm’s actions have an

effect on its rivals and induce a react by the rivals

 barriers to entry which can influence pricing behavior

 many theoretical models

The Cournot Model

 Duopoly – an industry with two firms

 Cournot Model – a model of oligopoly that assumes each

firm determines its output based on the assumption that any other firms will not change their outputs

 Equilibrium is reached when neither firm has any incentive

to change output

Figure 13.3 - The Cournot Model

Reaction Curves

 Reaction Curve – a relationship showing one firm’s most

profitable output as a function of the output chosen by the other firm(s)

 Cournot equilibrium occurs at the intersection of two

reaction curves:

 Total output is usually between that of pure monopoly and competition

 Price exceeds MC

Figure 13.4 – The Cournot Model with Reaction Curves

Evaluation of the Cournot Model

The assumption that each firm takes the output of a rival

firm as constant is implausible if the market is adjusting

toward equilibrium

However,

 if equilibrium is established, firms will not see the

assumption invalidated

 the assumption is more plausible the larger the number

of firms in the market

13.3 OTHER OLIGOPOLY MODELS

Compare several key noncooperative oligopoly models, including

Stackelberg and the dominant firm.

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

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

Figure 13.5 - The Stackelberg Model

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

Figure 13.6 - The Dominant Firm Model

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

The Elasticity of the Dominant Firm’s

Demand Curve

(continued)

13.4 CARTELS AND COLLUSION

Show how price and output are determined under the cooperative

oligopoly model of cartels.

Cartels and Collusion

 Cartel – an agreement among independent producers to

coordinate their decisions so each of them will earn

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

Figure 13.7 – A Cartel

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

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.

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

Figure 13.8 – OPEC Cartel as a

Dominant Firm