Imperfect Competition
Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.
Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.
Types
Types of Imperfectly Competitive Markets Monopolistic Competition
Many firms selling products that are similar but not identical.
OligopolyOnly a few sellers, each offering a similar or identical
product to the others.
Definition
Monopolistic CompetitionMany firms selling products that are similar but not
identical.
Markets that have some features of competition and some features of monopoly.
Attributes
Attributes of Monopolistic Competition Many sellers Product differentiation Free entry and exit
Attribute 1
Many Sellers There are many firms competing for the same
group of customers.Product examples include books, CDs, movies,
computer games, restaurants, piano lessons, cookies, furniture, etc.
Attribute 2
Product Differentiation Each firm produces a product that is at least
slightly different from those of other firms. Rather than being a price taker, each firm faces
a downward-sloping demand curve.
Attribute 3
Free Entry or Exit Firms can enter or exit the market without
restriction. The number of firms in the market adjusts
until economic profits are zero.
Short-Run Economic Profits
The Monopolistically Competitive Firm in the Short Run Short-run economic profits encourage new firms to enter
the market. This: Increases the number of products offered. Reduces demand faced by firms already in the market. Incumbent firms’ demand curves shift to the left. Demand for the incumbent firms’ products fall, and their profits
decline.
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Quantity0
Price
Profit-maximizing
quantity
Price
Demand
MR
ATC
(a) Firm Makes Profit
Averagetotal cost
Profit
MC
Short-Run Economic Losses
The Monopolistically Competitive Firm in the Short Run Short-run economic losses encourage firms to exit the
market. This: Decreases the number of products offered. Increases demand faced by the remaining firms. Shifts the remaining firms’ demand curves to the right. Increases the remaining firms’ profits.
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Demand
Quantity0
Price
Price
Loss-minimizing
quantity
Averagetotal cost
(b) Firm Makes Losses
MR
LossesATC
MC
Long-Run Equilibrium
Firms will enter and exit until the firms are making exactly zero economic profits.
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Quantity
Price
0
DemandMR
ATC
MC
Profit-maximizingquantity
P = ATC
Characteristics of Long-Run Equilibrium
Two Characteristics As in a monopoly, price exceeds marginal cost.
Profit maximization requires marginal revenue to equal marginal cost.
The downward-sloping demand curve makes marginal revenue less than price.
As in a competitive market, price equals average total cost.
Free entry and exit drive economic profit to zero.
Monopolistic versus Perfect Competition
There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.
Excess Capacity
Excess Capacity There is no excess capacity in perfect competition in the
long run. Free entry results in competitive firms producing at the
point where average total cost is minimized, which is the efficient scale of the firm.
There is excess capacity in monopolistic competition in the long run.
In monopolistic competition, output is less than the efficient scale of perfect competition.
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Quantity0
Price
Demand
(a) Monopolistically Competitive Firm
Quantity0
Price
P = MC P = MR(demand
curve)
(b) Perfectly Competitive Firm
MCATC
MCATC
MR
Efficientscale
P
Quantityproduced
Quantity produced =Efficient scale
Markup
Markup Over Marginal Cost For a competitive firm, price equals marginal
cost. For a monopolistically competitive firm, price
exceeds marginal cost. Because price exceeds marginal cost, an extra
unit sold at the posted price means more profit for the monopolistically competitive firm.
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Quantity0
Price
Demand
(a) Monopolistically Competitive Firm
Quantity0
Price
P = MC P = MR(demand
curve)
(b) Perfectly Competitive Firm
Markup
MCATC
MCATC
MR
Marginalcost
P
Quantityproduced
Quantity produced
Copyright©2003 Southwestern/Thomson Learning
Quantity0
Price
Demand
(a) Monopolistically Competitive Firm
Quantity0
Price
P = MC P = MR(demand
curve)
(b) Perfectly Competitive Firm
Markup
Excess capacity
MCATC
MCATC
MR
Marginalcost
Efficientscale
P
Quantityproduced
Quantity produced =Efficient scale
Monopolistic Competition and Welfare of Society
Monopolistic competition does not have all the desirable properties of perfect competition.
There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.
Monopolistic Competition and Welfare of Society
However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.
Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.
Advertising
When firms Sell differentiated products At price above marginal cost
Then, they have incentive to advertise To attract more buyers
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Key Feature
Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.
Characteristics
Characteristics of an Oligopoly Market Few sellers offering similar or identical products Interdependent firms Best off cooperating and acting like a
monopolist by producing a small quantity of output and charging a price above marginal cost
Simple Type: Duopoly
A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.
Duopoly Oligopoly with only two members Decide quantity to sell Price – determined on the market
By demand
Production Decisions
For a perfectly competitive firm Price = marginal cost Quantity = efficient
For a monopoly Price > marginal cost Quantity < efficient quantity
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Markets with a few Sellers
Duopoly Collude and form a cartel
Act as a monopoly Total level of production Quantity produced by each member
Don’t collude – self-interestDifficult to agree; Antitrust lawsHigher quantity; lower price; lower profit
Not competitive allocation
Nash equilibrium
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Collusion and Cartel
The duopolists may agree on a monopoly outcome. Collusion
An agreement among firms in a market about quantities to produce or prices to charge.
CartelA group of firms acting in unison.
Is Cartel Possible?
Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.
The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.
The equilibrium for an Oligopoly
When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.
The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).
Size of an Oligopoly
How increasing the number of sellers affects the price and quantity: The output effect: Because price is above
marginal cost, selling more at the going price raises profits.
The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.
Size of an Oligopoly
As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.
The price approaches marginal cost, and the quantity produced approaches the socially efficient level.
Strategic Action
Because the number of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.
Game Theory
Game theory is the study of how people behave in strategic situations.
Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.
Prisoners’ Dilemma
The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.
Often people (firms) fail to cooperate with one another even when cooperation would make them better off.
The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.
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Bonnie’ s Decision
Confess
Confess
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Bonnie goes free
Clyde gets 20 years
gets 1 yearBonnie
Clyde gets 1 year
Remain Silent
RemainSilent
Clyde’sDecision
Dominant Strategy
The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.
Dominant strategies in Prisoners’ dilemma:
_ Clyde: Confess
_ Bonnie: Confess
Nash Equilibrium & Best Outcome
Nash Equilibrium (self-interest): _ Clyde: Confess & Bonnie: Confess Best Outcome (cooperation): _ Clyde: Silent & Bonnie: Silent
Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.
Game Example: OPEC
Iraq and Iran: Members of OPEC Their decisions on oil production. Decisions: High Production or Low
Production
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Iraq’s Decision
High Production
High Production
Iraq gets $40 billion
Iran gets $40 billion
Iraq gets $30 billion
Iran gets $60 billion
Iraq gets $60 billion
Iran gets $30 billion
Iraq gets $50 billion
Iran gets $50 billion
Low Production
LowProduction
Iran’sDecision
Nash Equilibrium
Dominant strategies: _ Iran: High Production _ Iraq: High Production
Nash Equilibrium (self-interest): _ Iran: High Production & Iraq: High Production
Best Outcome (cooperation): _ Iran: low production & Iraq: low production
No Nash equilibrium in pure strategies
Competitor.com
NBA NHL
NBA W: 4, C: 3
W: 3, C: 4
We.com NHL W: 3,
C: 4 W: 4, C: 3
Where to advertise?
No Nash Equilibrium
Dominant strategies: _ We.com: none _ Competitor.com: none Nash Equilibrium (self-interest): _ We.com: none _ Competitor.com: none
Nash Equilibrium
Dominant strategies: _ ATV: none _ TVB: none Two Nash Equilibria (self-interest):
_ ATV: 7:30pm & TVB: 8:00pmor _ ATV: 8:00pm & TVB: 7:30pm
Why People Sometimes Cooperate
Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.
Repeated prisoners’ dilemma Encourage cooperation
Penalty for not cooperating
Better strategyReturn to cooperative outcome after a period of
noncooperation
Best strategy: tit-for-tatPlayer - start by cooperating
Then do whatever the other player did last time
Starts out friendlyPenalizes unfriendly playersForgives them if warranted
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Public Policy Toward Oligopolies
Controversies over antitrust policies Most commentators agree that price-fixing
agreements among firms should be illegal. Yet the antitrust laws have been used to condemn some business practices whose effects are not obvious. There are three examples of controversial business practice:Resale price maintenancePredatory pricingTying
Resale price maintenance
Resale price maintenance (fair trade) Require retailers to charge customers a given
price Might seem anticompetitive
Prevents the retailers from competing on price
Defenders:Not aimed at reducing competitionLegitimate goal: Prevent from free rider problem
Example
Superduper sells disc players to retailers for $100. Require retailers to charge customers a given price, say
$150. Might seem anticompetitive
Prevents the retailers from charging less than $150 Defenders:
Superduper would be worse off if its retailers were a cartel, so it is not aimed at reducing competition.
Legitimate goal of resale price maintenance Without resale price maintenance, some customers
would take advantage of one store’s service, and then buy the item at a discount retailer. Resale price maintenance prevents from free rider problem.
Public Policy Toward Oligopolies
Predatory pricing Charge prices that are too low
AnticompetitivePrice cuts may be intended to drive other firms out of
the market
SkepticsPredatory pricing – not a profitable strategyPrice war - to drive out a rival
Prices - driven below cost
Example
Coyote Air has a monopoly on some route. Roadrunner Express enters and takes 20% of the market.
Coyote’s anticompetitive move: slashing its fare. The price cut (predatory pricing) of Coyote intends to drive
Roadrunner out of the market. Prices have to be driven below cost.
Coyote sells cheap tickets at a loss, and low fares attract more customers. Therefore, Coyote had better be ready to fly more planes. Meanwhile, Roadrunner can respond to Coyote’s predatory pricing by cutting back on flights. As a result, Coyote ends up bearing more losses.
The predator suffers more than the prey.
Public Policy Toward Oligopolies
Tying Offer two goods together at a single price
Expand market power
SkepticsCannot increase market power by binding two goods
together
Form of price discriminationTying may increase profit
Example Makemoney Movie produces two films. It offers theaters the two films
(Film A is a blockbuster, and Film B is art film) together at a single price. Makemoney uses tying as a mechanism for expanding its market power. Skeptical: forcing a theater to accept a worthless movie as part of the
deal does not increase the theater’s willingness to pay. Makemoney cannot increase its market power simply by using tying.
Tying exists because it is a form of price discrimination. Suppose there are two theaters. Theater 1 is willing to pay $15000 for film A and $5000 for film B. Theater 2 is willing to pay $5000 for film A and $15000 for film B.
Pricing strategy for each film: $15000; Tying strategy for two films :$20000
Tying allows Makemoney to increase profit by charging a combined price.