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Summary Introduction to Economics - Parkin: Economics - Readings for Week 3

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Introduction to Economics

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Rijksuniversiteit Groningen (RuG)

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Economics

This document contains a comprehensive summary of all readings for Week 3 - so, for both lecture 5 and 6 - of the first-year IRIO course Introduction to Economics at the RUG.

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Introduction to Economics International Relations and international Organization

Week 3: Lecture 5 - Microeconomic government intervention (including oligopoly)
Monopolistic competition (p. 301-307)
What is monopolistic competition?
Most real-world markets are competitive, but not perfectly competitive because firms in these
markets have some power to set their prices as monopolies do. We call this type of market
monopolistic competition. Monopolistic competition is a market structure in which:
1. A large number of firms compete; this has three implications for the firms in the industry:
- Small markets share power to influence the price; each firm’s price can deviate from the average
market price by a relatively small amount
- No one firm’s actions influence actions of other firms, because all firms are relatively small
- Collusion (conspiring to fix a higher price) is impossible given the high number of firms
2. Each firm uses product differentiation: a firm makes product that is slightly different from the
products of competing firms (thus, it is a close substitute)
3. Firms compete on product quality, price and marketing
4. Firms are free to enter and exit the market

Price and output in monopolistic competition

So far, the firm in monopolistic competition looks like a single-price monopoly. It produces the
quantity at which marginal revenue equals marginal cost and then charges the price that buyers are
willing to pay for that quantity, determined by the demand curve. The key difference between
monopoly and monopolistic competition lies in what happens next when firms either make an
economic profit or incur an economic loss:
- Firms are not going to incur an economic loss for long, so, eventually, they go out of business.
- There is no restriction on entry in monopolistic competition, so, if firms in an industry are making an
economic profit, other firms have an incentive to enter that industry.
-> There will be a long-run equilibrium, which makes that there will be both no profit and loss

There are two key differences between monopolistic competition and perfect competition:
- Excess capacity: a firm has excess capacity if it produces below its efficient scale, which is the
quantity at which average total cost is a minimum (quantity at the bottom of the U-shaped ATC
curve). You see the excess capacity in monopolistic competition all around you: restaurants always
have some empty tables. In perfect competition, excess capacity = efficient scale
- Markup: a firm’s markup is the amount by which the price exceeds marginal cost. In perfect
competition, price always equals marginal cost and there is no markup. In monopolistic competition,
buyers pay a higher price than in perfect competition and also pay more than marginal cost.
-> see Figure 13.4 on page 306 for a clear illustration

,Introduction to Economics International Relations and international Organization

Oligopoly (p. 320-321)
What is oligopoly?
Oligopoly, like monopolistic competition, lies between perfect competition and monopoly. The firms
in oligopoly might produce an identical product and compete only on price, or they might produce a
differentiated product and compete on price, product quality and marketing. Oligopoly is a market
structure in which:
1. Natural or legal barriers prevent the entry of new firms:
- A natural barrier, as with a natural monopoly, creates a natural oligopoly if the economies
of scale and demand imply that there is no room for more firms in a market.
- A legal barrier, as with a legal monopoly, creates a legal oligopoly because of legal licensing
of companies (not) to enter a market.
2. Because barriers to entry exist, oligopoly consist of a small number of firms, each of which has a
large share of the market. Such firms are interdependent, but they face a temptation to cooperate to
increase their joint economic profit.
- Interdependent: with a small number of firms in a market, each firm’s actions influence the
profits of all of the other firms.
- Temptation to cooperate: when a small number of firms share a market, they can increase
their profits by forming a cartel and acting like a monopoly: limiting output, raising prices,
increasing economic profit

Reader text 2
Game theory demonstrates how competing firms in a oligopoly - assuming they are not informed in
advance about the decisions of their competitors - end up in the least profitable position for both, at
least if they do not find ways to cooperate. In an oligopoly, given the small number of firms, profits
depend on the market operations (behaviour) of the other company. All possible options can be
illustrated in a table; a matrix.

The prisoner’s dilemma is one of the most used and well-known examples of game theory. In facing
this dilemma, both companies choosing for a certain option which would be the best rational
outcome. However, the companies do not know what their competitors decide. Despite this
dilemma, game theory suggests there is a possible equilibrium; the so-called Nash equilibrium, also
known as the dominant strategy equilibrium. It is an equilibrium precisely because no company has
a reason to reconsider its strategy. This equilibrium is arrived at by considering the outcome of one’s
strategies based on the possible strategies of a competitor.

If there’s a Nash equilibrium, there’s an incentive for companies to start cooperating, for example by
creating a price cartel. A cartel is a way to avoid a price war between oligopolistic competitors.
Cartels, as a general rule, are not easy to maintain, because:
- if attractive, other firms also seek admission to the market and are thus complicating decision-
making;
- participating firms all have an incentive to cheat in order to produce more than their allocated
share (free-rider problem);
- high profits and prices will make it profitable for competitors to remain outside of the cartel: in that
way they can produce as much as they like and still profit from high prices;
- cartels and collusion to manipulate prices are strictly forbidden by several laws.

Monopoly (p. 291-293)
Monopoly regulation
Natural monopoly presents a dilemma: with economies of scale, it produces at the lowest possible
cost. But with market power, it has an incentive to raise the price above the competitive price and
produce too little - to operate in the self-interest of the monopoly and not in the social interest.

, Introduction to Economics International Relations and international Organization

- Regulation: rules administered by government agency to influence prices, quantities, entry and
other aspects of economic activity in a firm or industry, which is a possible solution to this dilemma
- Deregulation: process of removing regulation of prices, quantities, entry etcetera

Regulation is a possible solution to the dilemma presented by natural monopoly but not a
guaranteed solution. There are two theories about how regulation actually works:
1. Social interest theory: political and regulatory process relentlessly seeks out inefficiency and
introduces regulation that eliminates deadweight loss and allocates resources efficiently
2. Capture theory: regulation serves the self-interest of the producer, who captures the regulation
and maximises economic profit. Regulation that benefits the producer but creates a deadweight loss
gets adopted because the producer’s gain is large and visible while each individual’s consumer’s loss
is small and invisible. No individual consumer has an incentive to oppose the regulation, but the
producer has a big incentive to lobby for it.

A natural monopoly cannot always be regulated to achieve an efficient outcome. Two possible ways
of enabling a regulated monopoly to avoid an economic loss:
- Average cost pricing: an average cost pricing rule sets the price equal to average total cost. With
this rule, the firm produces the quantity at which the long-run average cost curve cuts the demand
curve. This rule results in the firm making zero-economic profit: breaking even.
- Government subsidy: direct payment to the firm equal to its economic loss. To pay a subsidy, the
government must raise the revenue by taxing some other activity.

Implementing average cost pricing represents the regulator with a challenge because it is not
possible to be sure what a firm’s cost are. So, regulators use one of two practical rules:
1. Rate of return regulation: a firm must justify its price by showing that its return on capital doesn’t
exceed a specified target rate. This can bring forth an incentive for the firm to inflate costs by
spending on unnecessary things and thus, to use more capital than the efficient amount.
2. Price cap regulation: a price ceiling - a rule that specifies the highest price the firm is permitted to
set. This gives a firm an opposite incentive: to operate efficiently and keep costs under control.
-> sometimes regulators might set the cap too high. For this reason, price cap regulation is often
combined with earnings sharing regulation - a regulation that requires firms to make refunds to
customers when profits rise above a target level.

Oligopoly (p. 334-337)
Antitrust law
Antitrust law is any law that regulates oligopolies and prevents them from becoming monopolies or
behaving like monopolies.
- Colluding with competitors to fix the price is always a violation of UK and EU antitrust law. If the
Competition agency can prove the existence of a price-fixing cartel, also called a horizontal price-
fixing agreement, defendants can offer no acceptable excuse. All price fixing is illegal, because it
shrinks consumer surplus and the outcome is inefficient

Other antitrust practices are more controversial and generate debate among lawyers and
economists. The three practices that will be examined are:
1. Resale price maintenance: distributor’s agreement with a manufacturer to resell a product at or
above a specified minimum price. This practice has been rendered illegal by some UK laws. The
question whether resale price maintenance create an inefficient or efficient use of resources, is
answered very differently by various economists:
- Inefficient resale price maintenance: by setting and enforcing the resale price, the
manufacturer might be able to achieve the monopoly price
- Efficient resale price maintenance: it might be efficient if it enables a manufacturer to
induce dealers to provide the efficient standard of service

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