MICROECONOMICS: Theory & Applications Chapter 13 Monopolistic Competition and Oligopoly By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9th Edition, copyright 2006 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Explain how price and output are determined under monopolistic competition. Understand the characteristics of oligopoly. Explore several key non-cooperative oligopoly models: Cournot, Stackelberg, and dominant firm. Show how price and output are determined under the cooperative oligopoly model of cartels. John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

Determination of Market Equilibrium The demand curve facing each firm is downward-sloping but fairly elastic. Long-run equilibrium is attained as a result of firms entering (or leaving) the industry in response to profit incentives. Figure 13.1 John Wiley & Sons, Inc. Copyright 2006

Monopolistic Competition and Efficiency Excess capacity – the result of firms failing to produce at lowest possible average cost Figure 13.2 John Wiley & Sons, Inc. Copyright 2006

Is Government Intervention Warranted? 3 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. John Wiley & Sons, Inc. Copyright 2006

Oligopoly 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 John Wiley & Sons, Inc. Copyright 2006

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. Figure 13.3 John Wiley & Sons, Inc. Copyright 2006

Reaction Curves Reaction Curve – a relationship showing one firm’s most profitable output as a function of the output chosen by other firms Figure 13.4 John Wiley & Sons, Inc. Copyright 2006

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. The assumption is more plausible the larger the number of firms in the market. John Wiley & Sons, Inc. Copyright 2006

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 John Wiley & Sons, Inc. Copyright 2006

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 Figure 13.5 John Wiley & Sons, Inc. Copyright 2006

The Dominant Firm Model 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. Figure 13.6 John Wiley & Sons, Inc. Copyright 2006

Comparison Between Oligopoly Models Different assumption about rival behavior In the Stackelberg model, the leader firm assumes Cournot behavior on the part of rivals. In the dominant firm model, the leader firm assumes competitive behavior. The dominant firm model is more appropriate when there are a sufficiently large number of fringe firms. John Wiley & Sons, Inc. Copyright 2006

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 John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

Cartelization of a Competitive Industry [Figure 13.7] John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

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