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Chapter 14: Oligopoly and Monopolistic Competition (Cartels (Why cartels…
Chapter 14: Oligopoly and Monopolistic Competition
Market structures
Oligopoly
: a small group of firms in a market with substantial barriers to entry
Noncooperative Oligopoly
Duopoly
: oligopoly with two firms
Duopoly equilibrium
: Set of strategies by both firms is Nash equilibrium if each firm's equilibrium strategy is best response to other firm's equilibrium strategy
Cartel
: group of firms that
collude
and explicitly agree to coordinate their activities (acts as monopoly in its purest form)
Monopolistic Competition
: a market structure in which firms have market power and no barriers to entry, so firms enter market until no additional firm can enter and earn a positive profit
From most to least market power, and least to most number firms: Monopoly, Oligopoly, Monopolistic Competition, Perfect Competition
Cartels
Why cartels form
Cartel forms if member believe they can raise profits by coordinating actions
Monopoly profits higher than sum of oligopolies or competitive firm
Why cartels fail
Cartels fail if non-cartel members can supply consumers with large quantities of goods
Each member of a cartel has an incentive to cheat on cartel agreement
Maintaining cartels
To keep firms from violating agreements, must be able to:
detect cheating and punish violators
keep illegal behaviour hidden from customers and government agencies
Laws against cartels
Sherman Antitrust Act in 1890 and Federal Trade Commission Act of 1914 prohibit firms from explicitly agreeing to take actions that reduce competition
Cartels persist because
believe they can avoid detection or that punishment is insignificant (e.g. $2 million fine for $1 billion profit)
able to coordinate their activity without explicitly colluding
international cartels and cartels within certain countries operate legally
OPEC
Organization of petroleum exporting countries started in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, Venezuela. (Plus Nigeria, UAE, and others today)
Control roughly 81% of global reserves, and 40-45% of world output
Mergers
Laws in most countries restrict ability of firms to merge if effect would be anticompetitive
Cost-efficiency gains
versus
Bigger market power / reducing competition
Cournot Oligopoly Model
Five assumptions for baseline model:
2) Firms have identical costs
3) Sell identical products
1) Two firms in market and no other firms can enter
4) Firms set their quantities simultaneously
5) Market lasts for only one period
To find q1, q2 and p
Residual demand function:
q1 = Q(p) - q2
Rearrange as:
p = x - q1 - q2
p = x - Q
Q = q1 + q2
To find best response function, maximize profit:
π = pq - C(q)
dπ1/q1 = MRr - MC = 0
MRr = MC
q1 = x - yq2
Plug one best response function into the other to find q1 and q2
Sub q1 and q2 into inverse demand equation to find p
MR = p(1 + 1/n𝜺) = MC
n = 1, Cournot firm is a monopoly
As n grows large 1/n𝜺 becomes closer to -∞ because 𝜺 is a negative number. And equation above becomes p =MC
Stackelberg Oligopoly Model
Instead of moving simultaneously in Cournot, one firm was
leader
and the other was
follower
To find q1, q2 and p
Find best response function for
follower
as per Cournot model
Plug
follower
best response function into
leader
profit function
Plug one
leader's
quantity into the
follower's
best response function find q2 (
follower's
quantity)
Maximize
leader's
profit to find q1 (
leader
quantity):
dπL/qL = MRr - MC = 0
MRr = MC
Comparison of Collusive, Nash-Cournot, Stackelberg, and Competitive Equilibria (For Duopoly)
If 2 firms colluded, they would maximize joint profits by producing the monopoly output, at the monopoly price
Highest to lowest equilibrium quantities: Price-taking equilibirum, Stackelberg equilibrium/ Cournot equilibrium, Cartel equilibrium (Note: for Stackelberg, leader produces more, and follower less).
Highest to lowest equilibrium prices: Cartel equilibrium, Stackelberg equilibrium/ Cournot equilibrium, Price-taking equilibirum (Note: for Stackelberg, leader has higher price, and follower lower price).
Monopolistic Competition
Observance that many industries
Sell similar yet differentiated products
Have markup over marginal cost (market power / price setter)
Few or large number of firms
Have close to zero economic profit
Assumptions
Demand for each firm taken as given, depending on total supply
No strategic interaction
Downward sloping demand
Zero profits through free entry
Some differences
Barriers to entry: Oligopoly has barriers to entry, but Monopolistic Competition has no barriers to entry
Competitive firms face horizontal residual demand curves, but Monopolistically competitive firms have downward sloping demand curves (because they have few rivals for example due to location, or sell differentiated products)
Monopolistically competitive equilibrium
Two conditions hold
Marginal revenue equals marginal cost (because firms set out to maximize profit
Price equals average cost (because firms enter until no further profitable entry is possible)