1. MICROECONOMICS: Theory & Applications
Chapter 13: Monopolistic Competition and Oligopoly
By Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
11th Edition, Copyright 2012
PowerPoint prepared by Della L. Sue, Marist College

2. 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.
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John Wiley & Sons, Inc.

3. 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.
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4. 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
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John Wiley & Sons, Inc.

5. Figure 13.1 - Determination of Market Equilibrium
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6. 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
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John Wiley & Sons, Inc.

7. Figure 13-2 – Alleged Deadweight Loss of Monopolistic Competition
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8. 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.
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John Wiley & Sons, Inc.

9. 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
many theoretical models
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John Wiley & Sons, Inc.

10. 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
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11. Figure 13.3 - The Cournot Model
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12. Reaction Curves
Reaction Curve – a relationship showing one firm’s most profitable output as a function of the output chosen by other firms
Cournot equilibrium occurs at the intersection of two reaction curves:
Total output is usually between that of pure monopoly and competition.
Price exceeds MC.
Price exceeds AC => economic profit > 0
Collusion can increase combined profits of firms.
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John Wiley & Sons, Inc.

13. Figure 13.4 – The Cournot Model with Reaction Curves
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14. 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.
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15. 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 2012
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16. 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? It depends upon the particular market under examination
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John Wiley & Sons, Inc.

17. Figure 13.5 - The Stackelberg Model
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18. 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.
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19. Figure 13. 6 - The Dominant Firm Model
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20. 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)
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21. The Elasticity of the Dominant Firm’s Demand Curve
(continued)
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22. 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.
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23. Figure 13.7 – A Cartel
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24. 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.
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25. 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.
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John Wiley & Sons, Inc.

26. 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.
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27. Figure 13.8 – OPEC Cartel as a Dominant Firm
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