Download Imperfect competition

Imperfect Competition
Assumptions/Features
1. Many buyers and sellers, all of whom are small-scale relative to the size of the market.
There is a large number of buyers and sellers, each of whom contributes only a fraction of market
supply/demand. For example, there are many producers of cigarettes in Ireland.
2. Products are similar, but not homogenous
The products are not identical, but are close substitutes. For example, a Wispa bar is very like an
Aero bar.
3. Each firm has a monopoly in its own brand of the product
For this reason, imperfect competition is sometimes known as Monopolistic Competition
As a result, firms in imperfect competition face a downward-sloping Demand/AR curve.
For example, Nestle is the only firm allowed to produce Kit Kat bars.
4. Product Differentiation
Firms practise product differentiation – creating new brands in an attempt to maximise market share.
For example, Ford produce the Ka, Fiesta, Focus, Mondeo, etc – all trying to capture different
sectors of the motoring market.
5. Freedom of Entry and Exit.
There are no restrictions preventing firms moving easily into and out of the industry.
6. Perfect Knowledge
Producers and consumers are fully aware of prices, profits being made and production technologies.
7. Profit Maximisation
Each firm will try to maximise profits (by producing where MC = MR)
Diagrams
Short Run
AR/MR Curves
In Imperfect Competition, the average revenue (AR)/demand curve facing the firm is downward-sloping.
This is because the firm has a monopoly in its own brand of the product, and to sell extra units, the firm must
lower its price. When AR is falling, the marginal revenue (MR) must be less than AR. This is because the
firm must lower its prices even further to sell additional units.
AC/MC Curves
These are as usual, with the U-shaped AC curve, and MC cutting AC at its lowest point.
Equilibrium Output
Because we assume each firm tries to maximise profits, they will produce where MC = MR. This gives the
equilibrium quantity, Q. Reading up from this point to the AC curve gives the cost per unit at this point, and
similarly reading up to the AR curve gives the revenue per unit.
Profit Levels
The difference between AC and AR is Super Normal Profit. The total Super Normal Profit earned is marked
by the shaded rectangle in the graph below. SNP is any profit over and above the minimum profit needed to
make it worth the firm’s while staying in the industry.
Transition from Short to Long Run
The market price for the whole industry is determined by the intersection of the market demand and supply
curves (as normal)
The Super Normal Profits from the Short Run attract more firms into the market. They know about these
profits, and there is nothing to stop them entering the industry. These can’t increase the supply of the specific
brand in which the firm has a monopoly, but they can provide close substitutes, and these reduce the demand
for the firm’s product (from D1 to D2 in the graph below). This causes the prevailing market price to fall
(from P1 to P2)
If too many firms enter the industry, the price falls so far that firms fail even to earn Normal Profit and some
firms leave the industry. Eventually market demand settles at a level that gives a price where firms can earn
Normal Profit, but no more than that.
Long Run
In the long run, the AR/MR/demand curve has fallen to a level where it intersects with AC at a point directly
above where MC = MR.
To maximise profits, the firm continues to produce where MC = MR.
However, in the long run AC = AR at this quantity, so Normal Profit, but no more is being earned.
Thus, in Long Run Imperfect Competition the firm produces where:
MC = MR and AR = AC