Imperfect CompetitionImperfect Competition

Shades of Gray between Perfect Competition

and Monopoly

Microeconomics - Dr. Dennis Foster

The SSppeeccttrruumm of Competition

Firms are primarily distinguished from each other

by the degree of competition they face:

Perfect Competitio

nMonopolistic Monopolistic CompetitionCompetition

ContestablContestable Marketse Markets

Oligopoly Cartels

Game Game TheoryTheory

Monopoly

Contestable Markets

There may be many firms …-- but, probably only a few.

This market appears to be an oligopoly …-- but, there aren’t significant barriers to entry.

In the long run, price must equal marginal cost …-- so, firms are allocatively efficient.

In the long run, price must equal average cost …-- so, firms only earn a “normal” profit.

Examples – Airlines, wine production …

Monopolistic Competition

Market structure when there are:Market structure when there are: many firms,many firms, no barriers to entry,no barriers to entry, each produces a “differentiated each produces a “differentiated product.”product.”

Examples: Restaurants, Convenience stores, Examples: Restaurants, Convenience stores, BarbersBarbers

Differentiation may be by Differentiation may be by

location!location!

Substitutes are not perfect.Substitutes are not perfect.

Advertising may contribute.Advertising may contribute.

Monopolistic Competition

Many sellers & easy entryMany sellers & easy entry

Sells differentiated productsSells differentiated products

- Can only earn economic profit in - Can only earn economic profit in SR.SR.- In LR, must earn only normal - In LR, must earn only normal profit.profit.

- Faces a downward sloping demand.- Faces a downward sloping demand.- Can raise price without losing all - Can raise price without losing all customers.customers.

Characteristics and ConsequencesCharacteristics and Consequences

Monopolistic Competition

ATC

MC

d

MR

quantity

price

P*

q *

ATC*

P**

q**

d**

MR**

While economic profits may be earned in the short While economic profits may be earned in the short run,run,

the entry of new firms will compete them away.the entry of new firms will compete them away.

Monopolistic Competition & Efficiency

Allocatively inefficient?Allocatively inefficient? - Yes, since demand slopes down, P>MC.

Productively inefficient?Productively inefficient? - Yes!!! Must be. [Excess Capacity Theorem]

Social waste of resources?Social waste of resources? - No, as there are no econ profits to protect.

X-inefficiency?X-inefficiency? - Unlikely, due to competition.

Oligopoly

Market structure where:Market structure where:

(i)(i) there are a few dominant there are a few dominant firmsfirms

(ii)(ii) there are high barriers to there are high barriers to entryentry

MR

quantity

MC

Price

P*

Q*

D2

D1

MR

quantity

MC

Price

P*

Q*

D2

D1

MC

Price

P*

Q*

D2

D1

Oligopoly … characteristics Few sellersFew sellers

- face downward sloping demand, - actions are interdependentinterdependent.

Homogeneous or differentiated Homogeneous or differentiated productsproducts - steel, oil, concrete, diamonds - cigarettes, cereal, tires, soap

Barriers to entryBarriers to entry - can earn economic profit in long run.

Oligopoly … barriers to entry

Control of resourceControl of resource

Scale economiesScale economies

Brand proliferationBrand proliferation

Legal barriersLegal barriers

Deterrence strategiesDeterrence strategies

- price wars- switching costs- game theory

Oligopoly … models of behavior

Kinked DemandKinked Demand

Price LeaderPrice Leader

Cartel ModelCartel Model

Entry-limit PricingEntry-limit Pricing

Contestable Contestable MarketsMarkets

Game TheoryGame Theory

Graphicalanalyses

Descriptiveanalyses

Presumes excess capacityPresumes excess capacity - Others follow price reduction. - Nobody follows price increase. Price rigidity in the face of changing costsPrice rigidity in the face of changing costs

Oligopoly – Kinked Demand

MR

quantity

Price

P*

Q*

D2

D1

MC

Price LeaderPrice Leader - One firm sets the price; others follow.

- To be enforceable, this firm should dominate the market (Saudi Arabia).

- Sometimes it is just by convention (Ford).

Entry-limit pricingEntry-limit pricing - Firms set price so any new entrant will force price down below ATC.

- This is a barrier to entry.

Contestable MarketsContestable Markets

Oligopoly – Other Models

Allocatively inefficient?Allocatively inefficient?

Productively inefficient?Productively inefficient?

Social waste of resources?Social waste of resources?

X-inefficiency?X-inefficiency?

Oligopoly - Efficiency

- It is not certain, but likely.

- Yes, since demand slopes down, P>MC.

- Yes, as there are likely to be economic profits to protect.

- Yes, especially if the market is regulated.

Firms colludeFirms collude - Try to act as if it were a monopoly. - Must increase excess capacity – incentive to cheat. BOAPW – Be the only one not to join!BOAPW – Be the only one not to join!

Oligopoly – Cartel Model

demand

MR

P*

Q*

MCATC

P**

Q**

Price

quantity

Free rider problem.Free rider problem. - Non members get advantage of higher price without having to control output.

Raising profits encourages entry!Raising profits encourages entry! - OPEC and . . . Mexico/North Sea/Alaska

There must be few substitutes.There must be few substitutes. - A cartel for coffee?

Must be able to deter cheating by Must be able to deter cheating by members.members. - Libya and oil; Iran & Iraq and oil. - Diamonds (DeBeers) and distribution/stocks

Oligopoly – Cartel Model

Models of oligopoly behavior Models of oligopoly behavior

based on the characteristic based on the characteristic

of of interdependenceinterdependence..

Game TheoryGame Theory

Cooperative vs. Cooperative vs.

NoncooperativeNoncooperative

Dominant strategyDominant strategy

Sequential gamesSequential games

Games with Nash equilibriumGames with Nash equilibrium

Read Chapter 24 for more on

Game Theory.

First-mover gameFirst-mover game

Last-mover gameLast-mover game

Chicken gameChicken game

Prisoner’s DilemmaPrisoner’s Dilemma

Game TheoryGame Theory

Should Bud and Miller advertise during the Super

Bowl?

The Prisoners’ The Prisoners’ DilemmaDilemma

$100 $100

$200

$200

$50

$50

$150 $150

Advertise Don't Advertise

Advertise

Don't Advertise

Bud

Miller

The best outcome (for them) is . . . The best outcome (for them) is . . .

But, each has the same “best” strategy . But, each has the same “best” strategy . . .. .

How can these firms overcome the PD?How can these firms overcome the PD?

Game TheoryGame Theory

The SSppeeccttrruumm of Competition

Firms are primarily distinguished from each other

by the degree of competition they face:

Perfect Competitio

nMonopolisti

c Competitio

nContestable Markets

Oligopoly Cartels

Game TheoryGame Theory

Monopoly

Imperfect CompetitionImperfect Competition

Shades of Gray between Perfect Competition

and Monopoly

Microeconomics - Dr. Dennis Foster