EC-103Semester 2

Lectures 6 & 7

Market structure and Imperfect Competition

Most markets fall between the two extremes of monopoly and perfect competition

• An imperfectly competitive firm– would like to sell more at the going price

– faces a downward-sloping demand curve

– recognizes its output price depends on the quantity of goods produced and sold

© The McGraw-Hill Companies, 2002

Imperfect competition

• An oligopoly– an industry with a few producers

– each recognizing that its own price depends both on its own actions and those of its rivals.

• In an industry with monopolistic competition– there are many sellers producing products that are close

substitutes for one another

– each firm has only limited ability to influence its output price.

© The McGraw-Hill Companies, 2002

4

Market structure

Numberof firms

Ability toaffectprice

Entrybarriers

Example

Perfect competition

Imperfect competition:

Monopolistic competition

Oligopoly

Monopoly

Many

Many

Few

One

Nil

Small

Medium

Large

None

None

Some

Huge

Fruit stall

Corner shop

Cars

Post Office

© The McGraw-Hill Companies, 2002

Monopolistic competition

• Characteristics:– many firms

– no barriers to entry

– product differentiation• so the firm faces a downward-sloping demand curve

– The absence of entry barriers means that profits are competed away...

© The McGraw-Hill Companies, 2002

Monopolistic competition (2)

• Firms end up in TANGENCY

EQUILIBRIUM, making

normal profits

• Firms do not operate at

minimum LAC

• Price exceeds marginal cost

• Unlike perfect competition, the

firm here is eager to sell more

at the going market price.

P1=AC1

£

OutputQ1

DMR

AC

MC

F

© The McGraw-Hill Companies, 2002

Oligopoly

• A market with a few sellers

• The essence of an oligopolistic industry is the need for each firm to consider how its own actions affect the decisions of its relatively few competitors

• Oligopoly may be characterized by collusion or by non-co-operation

Collusion and cartels

• COLLUSION– an explicit or implicit agreement between

existing firms to avoid or limit competition with one another

• CARTEL– is a situation in which formal agreements

between firms are legally permittede.g. OPEC

Collusion is difficult if:

• There are many firms in the industry

• The product is not standardized

• Demand and cost conditions are changing rapidly

• There are no barriers to entry

• Firms have surplus capacity

The kinked demand curve

Q0

P0

Quantity

£Consider how a firm may perceive its demand curve under oligopoly.

It can observe the currentprice and output,

but must try to anticipaterival reactions to anyprice change.

Q0

P0

Quantity

£

The kinked demand curve (2)

The firm may expect rivalsto respond if it reducesits price, as this will be seenas an aggressive move

… so demand in response to a price reduction is likely to be relatively inelastic

The demand curve will be steep below P0.D

The kinked demand curve (3)

…but for a price increaserivals are less likely to react,

so demand may be relatively elasticabove P0

so the firm perceivesthat it faces a kinkeddemand curve.D

Q0

P0

Quantity

£

The kinked demand curve (4)

Given this perception, thefirm sees that revenue willfall whether price is increasedor decreased,

so the best strategy is to keepprice at P0.

Price will tend to be stable,even in the face of an increasein marginal cost.D

Q0

P0

Quantity

£

Game theory: some key terms

• Game– a situation in which intelligent decisions are

necessarily interdependent

• Strategy– a game plan describing how the player will act or

move in every conceivable situation

• Dominant strategy– where a player’s best strategy is independent of

those chosen by others

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Game Theory and the Economics of Cooperation

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.

Game Theory and the Economics of Cooperation

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 produced but also on how much the other firms produce.

The 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’ DilemmaBonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

The Prisoners’ Dilemma

The dominant strategy is the best strategy for a player to follow regardless of the strategies pursued by other players.

The Prisoners’ Dilemma

Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

Oligopolies as a Prisoners’ Dilemma

Iraq’s Decision

High Production

Low Production

High Production

Low Productio

n

Iran’s Decision

Iran gets $40 billion

Iraq gets $40 billion

Iraq gets $30 billion

Iraq gets$50 billion

Iraq gets $60 billion

Iran gets$30 billion

Iran gets $50 billion

Iran gets $60 billion

Oligopolies as a Prisoners’ Dilemma

Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

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.

The Prisoners’ Dilemma Game

Consider two firms in a duopoly each with a choiceof producing “high” or “low” output:

Firm B output

High Low

High 1 1 3 0

F

irm

A o

utp

ut

Low 0 3 2 2

The Prisoners’ Dilemma

• Each firm has a dominant strategy to produce high

• so they make 1 unit profit each• but they would both be better off producing

low– as long as they can be sure that the other firm

also produces low.• So collusion can bring mutual benefits• but there is incentive for each firm to cheat

More on collusion

• The probability of cheating may be affected by agreement or threats

• Pre-commitment– an arrangement, entered voluntarily, restricting

future options

• Credible threat– a threat which, after the fact, is optimal to carry

out

Strategic entry deterrence

• Some entry barriers are deliberately erected by incumbent firms:– threat of predatory pricing

– spare capacity

– advertising and R&D

– product proliferation

• Actions that enforce sunk costs on potential entrants