Two theories of Imperfect Competition Imperfect competition: more than one seller competes with other sellers;...each firm has control over the price

Two theories of Imperfect Competition Imperfect competition: more than one seller

competes with other sellers; ...each firm has control over the price they charge.• Two market structures lie between the two extremes

of Monopoly and Perfect Competition… Monopolistic competition & Oligopoly

• These two market structures are the most common in the economy…most goods and services are produced by firms that are monopolistically competitive or oligopolistic.

• The major differences between Monopolistic competition and Oligopoly is the number of firms in the industry and how much of the market those firms control.

Monopolistic competitionA. Characteristics 1. There are a relatively large number of firms. Each firm produces a small part of the total

market share in the industry. 2. Each firm produces a similar, but not identical

product... ...each firm produces a differentiated product

• These differences arise because of: the quality of good, packaging, image, service, brand name, etc.

However, each firm is said to be in the same Product Group...

...closely related, but not identical, goods that serve the same purpose for consumers.

Monopolistic competition 3. Relative freedom of entry and exit exist. The need to establish a differentiated product makes

entry slightly more difficult than perfect competition.B. Implications Because a firm only produces a small market share,

each firm will have little effect on the market share of other firms…

...so firm’s won’t react to other firms choice of output and price…

…moreover, because of the number of firms in the industry, cooperation to set price among firms is not possible.

Examples of Monopolistically competitive industries Percent of value of shipment of product Industry four eight twenty # of firmsSoftware Publishing 39.5 45.6 56.3 9,953Pharmaceutical prep. 37.1 52.7 74.1 707Book Publishing 32.3 45.2 58.9 690Men & Boys’ Dress Shirts 22.1 30.2 43.8 636Auto Parts 21.2 30.5 38.8 57,698Medical Equipment 18.6 32.4 54.7 12,123Jewelry 14.4 19.8 30.3 3,737Digital Printing 10.3 17.4 33.1 386Women’s & Misses’ Dresses 6.5 9.9 16.0 7,056These are national industries.• An example of monopolistic competition on a local level

is family restaurants……each one is fairly small, performs the same function, but

has different quality of food, different location, or different level of service, etc.

Price

quantity

d (perfect competitive firm)

Demand curve of a Monopolistic competitive firm

With Monopolistic Competition there are many other sellers, but each firm produces a DIFFERENTIATED product.

A perfectly competitive firm has a perfectly elastic demand curve1) There are many other firms 2) Each firm produces the exact

SAME good

Because it’s product is not a perfect substitute the monopolistic competitor can raise price and still sell some of it’s product.

d (monopolistic competitive firm)

P1

P2

q1 = q1 q2 q2

The monopolistic competitor’s ability to control the price of it’s good occurs because it’s product is DIFFERENTIATED instead of identical.

Price

quantity

d (perfect competitive firm)



P1

P2

q1 = q1 q2 q2

A Monopolist has control over it’s price because it is the market and it had no substitutes.

D (monopoly)

q2 = q1

A monopolistic competitor is but one among many firms and those firms produce closely related products….….Because of this, a monopolistic competitor’s demand curve will be more elastic than a monopolist’s. More elastic: more competition and more substitutes

Price

quantity

If this firm gains market share that is represented as an increase in demand.


The demand curve represents the market share that the firm enjoys relative to the total market.

d (increase in market share)

d (decrease in market share)


If this firm loses market share that is represented as a decrease in demand.

Monopolistic Competition: Short

run to Long Run

ATC $17

$20

q1

d1

MR1

Price

quantity

MCATC

AVC

q2

$16

$18

d2

MR2

Suppose d1 is the demand curve for this firm...…this Monopolistic Competitive firm will be able to make an Economic profit

•In the short run, a monopolistic competitive firm can make an economic profit, economic loss, or normal profit(not shown)•How much profit will depend on the relative market share(demand curve) and the cost of production.

What will happen in the long run?

What if market share were lower?

The demand curve would be lower…

…and the firm would make an economic loss.

A firm making economic profit

ATC $17

$20

q1

d1

MR1

What will happen in the long run?

If firms are making economic profit, potential new firms(that can produce with the same costs) will see the opportunity to make profit and enter the industryenter the industry

By doing so they take away market share from existing firms and their demand curves shift to the left (decrease).

Firms stop entering when economic profit in the industry is zero

Price

quantity

MCATC

dLR

MRLR

PLR=ATC

qLR

A firm making an economic lossAVC

$15

$18

q2

d2

MR2

MCATC

What will happen in the long run if firms are making economic losses?

If firms are making economic losses, some firms will exit the industry to do better (an industry “shake out”).As firms exit the industry the remaining firms gain market share, which shifts their demand curves to the right(increase)

Price

quantity

dLR

MRLR

PLR

=ATC

qLR

Firms stop entering when economic losses are eliminated(Earning Normal Profit)

MCATC

Price

quantity

dLR

MRLR

PLR

=ATC

qLR

Long Run EquilibriumIt is most likely that monopolistic competitive firms will only make a NORMAL PROFIT (P = ATC).This is similar to Perfect Competition MCLR

Price > MC

Minimum ATC (Capacity)

q: capacityPrice > minimum AC (Similar to Monopoly)

Compared to Perfect Competition, Monopolistic competition is neither Allocative or Productively efficient.Level of output is less than where AC is minimized. This is referred to as EXCESS CAPACITY.Based on efficiency, the Consumer is not as well off as under perfect competition. But is this REALLY true?

MCATC

Price

quantity

dLR

MRLR

PLR

=ATC

qLR

MCLR

Minimum ATC (Capacity)

q: capacity

Is the Consumer worse off in Monopolistic Competition?

It depends how consumers feel about having a variety of goods to consume...

The only way to reach minimum ATC is if the demand curve faced by the firm is perfectly elastic (only true in perfect competition)

dpc

The reason for the downward sloping demand curvedownward sloping demand curve in monopolistic competition is because of Product Differentiation.Product Differentiation.Pmc > Ppc , but if consumers value variety in goods and services perhaps they are willing to pay the difference.

If value to consumers of having a variety of goods > (Pmc > Ppc) , then consumers could be better off in monopolistic competition

Monopolistic Competition & Non-Price competition between firms• Because product differentiation exists in

monopolistic competition, firms need to make their product distinctproduct distinct from their competitors...

…they do this though advertising (non-price competition)

• By doing this they are able to increase market share and able to raise price without losing as many customers(decrease their price elasticity).

• Advertising leads to additional costs above production costs, which are called...

...Selling costs: the cost incurred by a firm to influence the sales of it’s product.

• This raises the total cost of the product, which the consumer will pay forconsumer will pay for.

MCATC

Price

quantity

dLR

MRLR

PLR

qLR

q: capacity

Selling Costs and Monopolistic Competition

(with Selling Costs)

ATC(without Selling Costs)

The light blue ATC curve could exist under perfect competition (no selling costs)

This makes the difference between Pmc > Ppc even larger.If the consumer values variety enough, they may still be better off with selling costs than under perfect competition

Examples of OligopoliesPercent of value of shipment of product

Industry four eight # of firmsCigarettes 98.9 100 9Chewing Gum 96Household Laundry equipment 90 99 10Beer 90 95 494Electric Lamp bulbs 89.7 94.1 54Cereal breakfast foods 86.7 94.7 48Motor vehicles 83 92 325Household refrigerators & freezers 82.8 97.6 21Credit Card Issuing 75.8 87.0 610College Bookstores 69.5 73.9 1,839Motorcycles 63.9 74.7 373Dog and Cat Food 63.4 83.2 129Soft Drinks 47.2 58.8 388

Oligopoly Assumptions or characteristics1. A few large firms that dominate total market share.2. Can produce a standardized or

differentiated product3. High barriers to entry... a)Economies of scale that give cost advantages to

existing (large) firms b)Large set-up costs for a large firm can prevent entry Costs of raising a large sum of money to buy

capital goods and equipment up front.Usually, this equipment is specialized for that particular

industry...…which means they are “Sunk” costs……costs that cannot be recovered upon exit of the

industry. Once incurred, you have them even if you fail c) The “cost” of establishing a brand name.

Oligopoly Implications of above assumptions:Firms are interdependent...

An Oligopolists’ control over price comes from the few amount of sellers in the industry and large market share of each firm…

…this means every time a firm changes price, quantity, or engages in non-price competition(advertising) to gain market share or revenue...

...it must be at the expense of other firms market share or revenue in that industry.

Oligopoly• Other firms must respond to changes in the price,

quantity, or non-price competition of it’s rival firms to try to prevent the loss in market share or revenue...

…each firm is aware of each other because decisions made by rival firms can hurt the profitability of other firms.

• Unlike the other 3 market structures, many types of behavior are possible with Oligopoly.

Different oligopolistic industries behave differently... …some oligopolies compete fiercely with each other

while some oligopolies cooperate with one another...…by cooperate...Do NOT change prices to take away

market share of other firms (make more profit together)

Oligopoly

Oligopolist’s dilemma: Cooperate or Compete• Although there are more than a few models on

oligopoly behavior, they can be divided into two two categoriescategories based on the Oligopolist’s dilemma.

Models where firms compete

Models where firms cooperate

Price

quantity of chewing gum

Kinked Demand Curve A single firm in the IndustrySuppose that firms have already established an equilibrium price for their product

P*

q*• If this firm were to cut price (from P*), other firms must also

cut price to avoid losing market share...…this firm would gain little additional sales (Inelastic demand)

Firms in this industry are interested in maintaining or gaining market share (from other firms)

D1(rival firms match price cuts;inelastic)

D2 (rival firms don’t match price increases; elastic)

What would the demand curve look like for a firm in such an industry?

If this firm were to raise price (from P*), other firms would keep their price the same (to get customers from this firm)......this firm would lose a lot of sales to it’s rival firms (elastic demand)

Price

quantity of chewing gum

Kinked Demand Curve A single firm in the Industry

P*

q*

Two implications canbe found in this model:

1) This firm has no incentive to change price from the original price. Any change in price will cause total revenue would decline

If Pd < 1 TR decreases as P decreasesIf Pd > 1 TR decreases as P increases

2) Costs of production may rise (MC2 > MC1), but the firm may still keep the same price and quantity.

Helps to explain why prices don’t change often in some oligopolies

Contestable markets A contestable market occurs when:

a) Entry is relatively easy and exit has low cost because...

…firms exiting the industry can dispose of assetscan dispose of assets by selling them elsewhere.

The set-up or “sunk” costs that are usual barriers to entry for an oligopoly are “recoverable” in a contestable market.

b) New firms can produce product at same cost as existing firms.

Examples: Trucking, airline service at small airports

Contestable MarketsPrice

quantity

MC

ATC

DMR

PM

qM

Firms in an industry that don’thave to worry about entry willmaximize profits(MR=MC)and charge the highest price they can (PM)

Firms will behave much like a Monopoly


quantity

MC

ATC

DMR

PM

qM

An Existing firm in a Contestable market

Price

quantity

MC

ATC

A potential New firm

If the market is contestable, then firms in the industry face the possible entry of new firms with the SAME COSTS.

If existing firms keep the price PM , this will encourage the potential new firms to enter (because they would make economic profit)


quantity

MC

ATC

DMR

PM

qM

An Existing firm in a Contestable market

Price

quantity

MC

ATC

A potential New firm

To prevent the entryprevent the entry of the potential new firms, Existing firms will be forced to charge a lower price (and produce more output).The only price that can keep new firms from entering would be very close to minimum ATC or competitive price (PC).

PCP = Minimum ATC

At that price no potential firm would enter because they could only earn normal profitnormal profit (only as well as current alternative)

Implications of Contestable Market theory

1. A small number of firms does not always imply a lack of a competitive outcome...

…firms in contestable markets may make close to or only a normal profit...

…if markets are contestable, an industry with few few firmsfirms may come close to the perfectly competitive outcome (P = MC = Min ATC)

2. Inefficient firms cannot survive because they can’t keep price low enough to prevent entry into the industry.

If an existing firms costs are higher than a potential new firm, that firm will fail.

It is the threat of entry(and not the actual entry) that keeps a contestable market competitive

Price leadership theory : tacit collusion• The industry usually has one dominant firm and

then a handful of smaller firms that would compete against one another.

The dominant firm sets it’s price to maximize it’s profits...

…the other firms follow by setting their prices close to (or equal) to the dominant firms price.

Example: Most large airports are dominated by one airline...

...when that airline raises fares, the other airlines usually follow.

Price leadership theory : tacit collusion Why would the smaller firms follow the dominant firm? 1) Fear retaliation of the dominant firm if they attempt

to gain market share through cutting price.Dominant firm could practice Predatory pricing......cutting price far enough below average costs to put

rival firms out of business (illegal in the United States)2) The smaller firms believe that the dominant firm has

better information than they do about the industry. In the banking industry, small banks may follow

interest rate changes by large banks Industries with equal size firms can use:

Cost-Plus pricing... Firms charge a certain % above average costs. Since costs are virtually the same for all firms, prices

will be too.

Cartel theory: explicit collusion A Cartel is a group of firms that act together to

coordinate output decisions and control prices. In other words, act like a monopoly.

Conditions needed to establish and maintain a Cartel:Conditions needed to establish and maintain a Cartel: 1) Large barriers to entry and few good substitutes…to prevent other sellers from entering at the high

prices that the cartel will establish. 2) Divide up the joint (monopoly) profit by......establishing quotas on the amount of output

produced for each firm.......so that the industry produces the monopoly output.Or use Market segmentation....each firm gets a “part”

of the market and that firm has the responsibility to enforce the cartel price in their part of the market.

Price(perbarrel)

quantity of oil

A single firm in the cartel3) Make sure that no firm exceeds their quota

This also happens to be the competitive price... …so this firm initially produces the competitive output at q1$25

q1

• Suppose firms in this industry then form a cartel and set a price to maximize joint monopoly profits.

$100

qquota

MCATC

Before a cartel is formed the price of oil would be $25

The only way this price can be maintained is if ALL FIRMS produce only their output QUOTA

This firm will now make economic profit (green area)

Price(perbarrel)

quantity of oil


q1

$100

qquota

MCATC

This firm (and all otherfirms in the cartel) will continue to make economic profit if they ALL stay within their quotas

But this firm(as well as other cartel firms) is NOT maximizing profits at the price of $100.

This firm can make EVEN MORE PROFIT by cheatingcheating on it’s production quota and adding the Peach area to profit(P=MC)

qcheat

This increase in profit can only work if IT IS THE ONLY FIRM that cheats (So market price stays at $100)...

…but each firm in the cartel hasan incentive to cheat to gain

greater economic profit

Price(perbarrel)

quantity of oil


q1

$100

qquota

MCATC

qcheat

…but each firm in the cartel has an incentive to cheat to gain greater economic profit

Since all firms have thesame incentive to cheat, itis likely enough will cheatto vastly increase the vastly increase the supply of the good.supply of the good.

If all firms cheat, the price declines back to competitive levels and firms end up making zero economic profit.

Unless firms can find a way to prevent cheatingprevent cheating on production quotas, collusion to raise prices will failcollusion to raise prices will fail

There is no legal way to prevent cheating, because cartels are usually illegal in most countries

$25

Cartels are most successful if:

1) There are very few firms: usually less than 5

2) Easy to detect quota violations

3) Entry barriers are very high

4) No anti-trust legislation in the country

Game theory• In an oligopoly, firms are interdependent and must

act and react to what rival firms will do.

• Game theory allows us to analyze the strategic interaction of firms that are interdependent

• Games consist of:

1) Rules: How many players, players options, etc.

2) Strategies: price changes, quantity changes, product changes, advertising changes, etc

3) Payoffs: winning, profit

• Example: Cartel theory.....the dilemma of keeping your agreement (quota) or cheating.

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat

Here is an examplewith two softdrink firms:

1 2

3 4

• Vanilla corp. and Lemons Ltd. are two firms that make up this soft drink industry.

• They have two strategies....1) enter into a cartel with the other firm and keep to the quota the maximizes the joint profit, or...

2) break the agreement...cheat on the quota (which can make even more profit if the other firm does not cheat)

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat

Vanilla profit = $500,000

Lemon profit = $500,000





1 2

3 4



If both firms keep the quota they split the joint profit of $1,000,000 (the intersection of keep quotas{Box 1})

If one firm decides to cheat, while the other firm sticks to the quota, the cheating firm gains more profit at the expense of the

other firm (Box 2 and 3)If both firms cheat they end up with profits that are close to the

competitive level (Box 4)


Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat







1 2

3 4




Question: Which strategy should each firm take in this game? Answer: It depends on how the game will be played!Let’s start off by assuming that each firm only gets ONE

SHOT at choosing a strategyEach firm knows the payoffs that will be received.

Each firm chooses a strategy at exactly the same time.

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat







1 2

3 4



Game with nocommunicationbefore choosing strategy

For Vanilla corp:If Lemons Ltd. keeps the quota, Vanilla does better if it cheats.If Lemons Ltd. cheats, Vanilla also does better if it cheats.

No matter the strategy Lemons Ltd chooses, Vanilla would ALWAYS choose to CHEAT.

Called a Dominant strategy...a strategy that is best no matter what the opposition does

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat







1 2

3 4



Game with nocommunicationbefore choosing strategy

Lemons Limited will face the same decisions and so will have a dominant strategy to cheat as well.

Both firms in this ONE SHOT game will decide to cheat and end up in Box 4 with $150,000 in profit each.

What if we could change the game so that each firm could communicate with one another before making a choice.

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat







1 2

3 4



Game where firmscan communicatebefore choosing strategy

Since both firms make more profit in box 1 than box 4 they could both agree to keep the quota so both can be better off.

...and if one firm cheats, it is then in the other firms interest to cheat as well (End up back in Box 4)

Dilemma: Once this cooperative decision is reached, each firm is tempted to cheat on the other firm to increase profit...

Vanilla corporation

LemonsLimited

Keep Quota Cheat

KeepQuota

Cheat







1 2

3 4



Game where firmscan communicatebefore choosing strategy

But if both firms know that if they cheat the other will as well…

...this could prevent the first firm NOT TO CHEAT in the first place! (Will stay in Box 1)

If cheating is easy to discover, then cooperative agreements may be easier to maintain.

Orange corporation

Blue.com

Monopoly Price

Competitive price

Enter & set Price Below Orange’s Price

NotEnter

Orange: Economic Loss

Blue: Economic Profit

Orange: Monopoly Profit

Blue: Normal Profit


Blue: Economic Loss

1 2

3 4

Orange: Normal Profit

Blue: Normal Profit

Here is an example:An Entry - Deterrence Game

Orange is the only firm in a contestable marketIf Orange sets the monopoly price then Blue.com will undercut

that price, take the market and earn economic profit and leave Orange with an Economic loss(Box 1)If Orange sets the competitive price then Blue.com will not enterwill not enter because if they do they would have to charge below ATC and make an economic loss. They stay out and make a Normal Profit and so does Orange.

Orange corporation

Blue.com

Monopoly Price

Competitive price

Enter & set Price Below Orange’s Price

NotEnter


Blue: Economic Profit

Orange: Monopoly Profit

Blue: Normal Profit


Blue: Economic Loss

1 2

3 4

Orange: Normal Profit

Blue: Normal Profit

Here is an example:An Entry - Deterrence Game

Orange is the only firm in a contestable marketOrange has two choices: Box 1 or Box 4: To avoid an economic

loss they practice Limit Pricing - charging a price to keep potential competitors out of the market: A MaxiMin strategy.

Because of the threat of Potential Entry Orange can’t Because of the threat of Potential Entry Orange can’t take advantage of it’s market dominancetake advantage of it’s market dominance

Case study in Oligopolies Soft - Drink industry• Nationally: Coke 35% Pepsi 29% Independents 28% Have battled for market share over the country,

especially in those areas where the other has a greater market share.

• Compete by advertising and by price Example: In 1988 Coke responded to Pepsi’s 6% market

hare in Phoenix by selling six-packs for $0.59.• In 1986 Coke was set to buy Dr. Pepper, but the

government prevented the merger.• Pepsi was set to buy 7-up at same time but after Coke

was prevented from buying Dr. Pepper backed down.• Result: No change in market share and small

independent firms still survive.

Summary of Oligopoly• Firms have an incentive to cooperate or collude in

order to make large profits.• Yet, each firm has an incentive to break their

agreement to make even greater profit.• There is a mix of oligopolies that cooperate and

compete and therefore there is no one theory of oligopoly.

• Many oligopolies will produce at P > MC and P> AC and not be efficient.

• Firms will Advertise to establish a brand name to increase set-up costs.

• Advertising (non-price competition) is considered more friendly competition than changing the price of the good.

Documents

Two theories of Imperfect Competition Imperfect competition: more than one seller competes with other sellers;...each firm has control over the price