Monopolistic Competition and Oligopoly

Monopolistic Competition
Definition: A market structure where firms can freely enter or exit, each producing a differentiated version of a product. Although products are close substitutes, they are not perfect substitutes, allowing each firm some degree of market power.

Characteristics:

• Differentiated products that are close, but not perfect, substitutes.
• Free entry and exit, ensuring that in the long run, economic profits tend to zero.

Short-Run Dynamics:

• Firms face a downward-sloping demand curve, granting them monopoly power over their specific product variant.
• Price (P) exceeds Marginal Cost (MC), and firms may earn positive economic profits if Price also exceeds Average Cost (AC).

Long-Run Equilibrium:

• Entry of new firms erodes profits. Eventually, P = AC, and economic profits dissipate, even though P > MC.
• The result is a deadweight loss and inefficiency compared to perfect competition, but consumers benefit from greater product variety.

Comparison with Perfect Competition:

• Perfect Competition: P = MC, no deadweight loss.
• Monopolistic Competition: P > MC, creating some inefficiency. However, the gain in product diversity partially offsets this inefficiency.

---

Oligopoly

Definition: A market structure dominated by a few large firms, where entry barriers limit competition. Firms’ decisions are interdependent and strategic.

Characteristics:

• A few firms produce most or all output.
• Products may be either homogeneous or differentiated.
• Barriers to entry prevent new firms from entering easily.

Examples: Automobiles, steel, aluminum, petrochemicals, electrical equipment, computers.

Equilibrium in Oligopoly:

• Firms set prices or outputs while considering their rivals’ potential responses.
• Nash Equilibrium: Each firm chooses its best strategy given the strategies of others. No firm can profit by unilaterally changing its own decision.

Oligopoly Models:

1. Cournot Model:
   • Firms produce a homogeneous product and choose output simultaneously.
   • Each firm’s output decision depends on its rivals’ output (the reaction curve).
   • The Cournot equilibrium is reached when each firm’s output choice is optimal, given the other firms’ outputs.
2. Stackelberg Model:
   • One firm (the leader) chooses output first, and the others (followers) choose afterward.
   • The leader leverages its first-mover advantage to constrain the followers’ choices and secure higher profits.
3. Bertrand Model:
   • Firms choose prices simultaneously, assuming rivals’ prices are fixed.
   • With homogeneous products, even a slight undercut in price can capture the entire market, leading often to outcomes similar to perfect competition (P = MC).

Game Theory and Oligopoly:

• Prisoners’ Dilemma: Although all firms would be better off colluding to raise profits, each faces an incentive to undercut, leading to more competitive outcomes and lower profits.

Collusion and Price Rigidity:

• Cartels: Groups of firms that explicitly agree on prices and outputs. Cartels are more stable when demand is inelastic and the cartel controls most supply. However, most cartels fail over time due to cheating, entry, and changing market conditions.
• Price Leadership: A form of implicit collusion where one firm sets a price and others follow.
• Price Rigidity: Firms resist changing prices, fearing that any deviation may trigger a price war.

---

The Goods Market in an Open Economy

Demand for Domestic Goods:
In an open economy, demand for domestic goods equals domestic demand (C + I + G) minus imports plus exports.

Increase in Domestic Demand:

• In an open economy, an increase in domestic demand raises output by less than in a closed economy because some demand spills over onto imports.
• This reduces the positive impact on domestic output and worsens the trade balance.

Increase in Foreign Demand:

• Higher foreign demand (increased exports) boosts domestic output and improves the trade balance.
• Countries may prefer waiting for foreign demand to recover from recessions rather than boosting domestic demand.

The Need for Coordination:

• In global recessions, coordination among countries can lead to collective recovery. Without it, countries may wait for others to stimulate demand.

Marshall-Lerner Condition:

• A real depreciation (a fall in the relative price of domestic goods) eventually increases net exports. In the short run, the trade balance may worsen before improving (the J-curve effect).

Equilibrium Condition in the Goods Market:

• The condition for equilibrium can also be written as: (Saving – Investment) = Trade Balance.
• A trade surplus indicates that saving exceeds investment, while a trade deficit implies that investment exceeds saving.

---

Fiscal Policy

Definition: Government’s choice of taxes and spending.

Fiscal Expansion:

• Increasing government spending or cutting taxes raises the budget deficit and stimulates output in the short run.

Fiscal Contraction (Consolidation):

• Cutting government spending or increasing taxes reduces the budget deficit, aiming for long-term sustainability.

Budget Cycle:

1. Preparation: Executive branch (e.g., Department of Budget and Management).
2. Authorization: Legislative branch (Congress).
3. Execution: Executive agencies (e.g., Department of Public Works and Highways).
4. Accountability: Auditing agency (Commission on Audit).

Primary Deficit:

• Primary Deficit = Government Spending (G) – Taxes (T).
• Persistent deficits increase government debt, which eventually requires tax hikes.

Inevitable Tax Increases:

• A reduction in current taxes necessitates higher future taxes, especially if interest rates are high or the delay is long.

Debt Stabilization:

• To stabilize debt, eliminate the deficit and achieve a primary surplus equal to interest payments on existing debt.

Evolution of the Debt-to-GDP Ratio:

• Depends on interest rates, growth rates, initial debt ratio, and the primary surplus.

Ricardian Equivalence Proposition:

• In theory, larger deficits are offset by private saving, leaving demand and output unchanged.
• In practice, it rarely holds: large deficits tend to boost short-run output but reduce long-run capital accumulation and growth.

Cyclically Adjusted Deficit:

• Measures what the deficit would be under current policies if the economy were at potential output.
• Suggests running deficits during recessions and surpluses during booms.

Deficits During Wars:

• Often justified due to extreme spending needs, shifting some costs to future generations.

High Debt Ratios:

• Increase the perceived risk of default and force higher interest rates, possibly triggering a “debt explosion.”

Debt Explosion:

• A vicious cycle where growing debt and higher interest costs lead to default or money financing.

Money Finance:

• Forcing the central bank to buy government bonds with newly created money risks hyperinflation and severe economic disruption.

---

Fiscal Policy 2

Budget Process and Recurrent Costs:

• Government budgets combine capital (infrastructure, development) and current (maintenance, wages) expenditures.
• In developing countries, neglecting recurrent costs can waste capital investments.

Taxation in Developing Countries:

• Heavy reliance on indirect taxes (sales, VAT, customs) due to administrative complexity in collecting income and capital gains taxes.
• Tax reform focuses on simplifying tax systems and introducing VAT for better compliance.

Tax Code Complexity:

• Complex codes increase corruption and distort the economy.
• Simpler codes reduce distortions and administrative burdens.

Progressive Taxation:

• Taxes should reflect ability to pay; however, in developing countries, effective progressive taxation is challenging.
• Measures like exempting basic goods from sales taxes help maintain equity.

Incidence of Taxes:

• Intended progressive taxes can become regressive in practice.
• Tax reforms should ensure that the burden of taxation aligns more closely with ability to pay.

Functions of Fiscal Policy:

1. Allocation: Provision of public goods and services.
2. Distribution: Influencing the distribution of income and wealth.
3. Stabilization: Achieving stable employment, stable prices, and sustained economic growth.

---

Financial Development and Inflation

Money Supply:

• The stock of liquid assets in the economy. It is defined in progressively broader measures (M1, M2, M3).

Inflation as a Tax:

• Moderate inflation can raise government revenue and investment without harming growth.
• High inflation discourages holding liquid assets, hindering financial development and economic growth.

Exchange Rate Systems and Inflation:

• Under fixed exchange rates, global inflation passes directly into the domestic economy.
• Under floating exchange rates, domestic inflation is driven by local monetary conditions.

Controlling Inflation:

• Open-market operations and interest rate policies are more efficient methods of controlling inflation but are harder to implement in less developed financial systems.
• Credit ceilings and reserve requirements are second-best tools when more refined methods are unavailable.

Financial Panics:

• Despite regulatory improvements, financial crises remain possible, as seen in the late 1990s and 2007–09 episodes.

Real Interest Rate:

• The nominal interest rate adjusted for inflation. A positive real interest rate encourages holding liquid assets, promoting financial deepening and growth.

Financial Institutions:

• As economies grow, they require a range of institutions (stock and bond markets, insurance companies, development banks) to support long-term financing.

Informal Financial Markets:

• Serve those with limited resources but often charge very high interest rates.

Microfinance:

• Offers more formal, affordable credit options to underserved communities. Its overall long-term impact on poverty reduction remains debated.

---

Output, Interest Rates, and Exchange Rates in an Open Economy

Determinants of Domestic Demand:

• In an open economy, domestic demand depends on both the interest rate and the exchange rate.
• Lower interest rates and currency depreciation both tend to increase domestic demand.

Interest Parity Condition:

• The domestic interest rate equals the foreign interest rate plus the expected depreciation of the domestic currency.
• This links domestic monetary conditions to external factors.

Exchange Rate Adjustments:

• An increase in the domestic interest rate typically appreciates the currency.
• A decrease in the domestic interest rate typically depreciates the currency.

Exchange Rate Regimes:

• Flexible (Floating) Exchange Rate: The value of the currency fluctuates with market conditions, giving policymakers more control over monetary policy but less exchange rate stability.
• Fixed Exchange Rate: The currency is pegged to another currency or basket of currencies. While this provides stability, it requires the domestic interest rate to match the foreign interest rate, reducing the effectiveness of independent monetary policy.

Under Fixed Exchange Rates:

• Monetary policy freedom is limited. The central bank must align interest rates with foreign rates.
• Fiscal policy becomes more effective because monetary policy must accommodate fiscal changes to maintain the fixed exchange rate.

---

Monetary Policy

Definition:

• Central bank decisions on money supply and interest rates.

Monetary Expansion:

• Increasing the money supply lowers interest rates, stimulating investment and output.

Monetary Contraction (Tightening):

• Decreasing the money supply raises interest rates, cooling down inflation and reducing output growth.

Money and Its Functions:

• Money serves as a medium of exchange, unit of account, store of value, and standard of deferred payment.

Measures of Money Supply:

• M1: Currency, traveler’s checks, and checkable deposits.
• M2: M1 plus savings deposits, money market funds, and time deposits.
• M3: A broader measure including additional liquid assets.

Neutrality of Money:

• In the long run, changes in nominal money supply affect only the price level, not real output or the interest rate.

Inflation:

• Persistent increases in the general price level.
• Historically, economists focused on money growth targeting, but the weak correlation with inflation led to inflation targeting regimes.

Inflation Targeting and the Taylor Rule:

• Central banks now target a low, stable inflation rate (often around 2%).
• The Taylor Rule guides policymakers by adjusting the nominal interest rate in response to deviations in inflation and unemployment from their targets.

Natural Rate of Unemployment and the Phillips Curve:

• The natural rate is where inflation is stable.
• The Phillips Curve shows the relationship between inflation and unemployment. Initially seen as a direct trade-off, it’s now understood that only unexpected changes in inflation affect unemployment.

Optimal Rate of Inflation:

• Moderate positive inflation (around 2%) is widely considered optimal to avoid the zero lower bound and provide flexibility in monetary policy.

Unconventional Monetary Policy:

• When interest rates approach zero, central banks use quantitative easing and other tools.
• The future challenge is determining when and how to shrink central bank balance sheets and whether these tools should be standard practice.

Macroprudential Tools:

• Regulators employ measures to limit credit bubbles, control systemic risk, and ensure financial stability.
• Stable inflation alone is not sufficient for overall macroeconomic stability.