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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 competition
A. 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 firms
Software Publishing
39.5
Pharmaceutical prep.
37.1
Book Publishing
32.3
Men & Boys’ Dress Shirts 22.1
Auto Parts
21.2
Medical Equipment
18.6
Jewelry
14.4
Digital Printing
10.3
Women’s & Misses’ Dresses 6.5
45.6
52.7
45.2
30.2
30.5
32.4
19.8
17.4
9.9
56.3
74.1
58.9
43.8
38.8
54.7
30.3
33.1
16.0
9,953
707
690
636
57,698
12,123
3,737
386
7,056
These 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
Demand curve of a Monopolistic competitive firm
A perfectly competitive firm has a
perfectly elastic demand curve
1) There are many other firms
2) Each firm produces the exact
SAME good
P2
P1
d (perfect competitive firm)
d (monopolistic competitive firm)
q2
q2
q1 = q1
quantity
With Monopolistic Competition there are many other sellers,
but each firm produces a DIFFERENTIATED product.
Because it’s product is not a perfect substitute the monopolistic
competitor can raise price and still sell some of it’s product.
The monopolistic competitor’s ability to control the price of it’s
good occurs because it’s product is DIFFERENTIATED
instead of identical.
Price
Demand curve of a Monopolistic competitive firm
P2
P1
d (perfect competitive firm)
d (monopolistic competitive firm)
q2
q2
D (monopoly)
quantity
q2 q1 = q1=
q1
has control
A Monopolist
over it’s price because it is the market
and it had no substitutes.
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
Demand curve of a Monopolistic competitive firm
The demand curve represents the market share
that the firm enjoys relative to the total market.
d (increase in market share)
d (monopolistic competitive firm)
d (decrease in market share)
quantity
If this firm gains market share that is represented as an
increase in demand.
If this firm loses market share that is represented as a
decrease in demand.
Monopolistic Competition:
Short run to Long Run
Price
M
C
$20
$18
ATC
$17
$16
ATC
What if market
Suppose
d1 is the
demand
curve
for this
share were
lower?
firm...
The
demand
curve
…this
Monopolistic
would
be lower…
Competitive
firm will
AVC
be…and
able tothe
make
an
firm
Economic profit
d1
would make an
d2
economic loss.
MR1
MR2
q2
q1
quantity
•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?
Price
M
C
What will happen in
the long run?
ATC
A firm making economic profit
$20
PLR
ATC
=$17
ATC
Firms stop entering
when economic profit
in the industry is zero
d1
dLR
MR1
MRLR
qLR q1
quantity
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 industry
By doing so they take away market share from existing
firms and their demand curves shift to the left (decrease).
Price
M
C
$18
PLR
=
ATC
$15
What will happen in
the long run if firms
are making economic
losses?
ATC
AVC
dLR
A firm making an economic loss
Firms stop entering
when economic losses
are eliminated(Earning
Normal Profit)
d2
MRMR
2
LR
qq
2 LR
quantity
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
Minimum ATC
(Capacity)
M
C
ATC
PLR
=
ATC
dLR
MCLR
Long Run Equilibrium
It is most likely that
monopolistic
competitive firms will
only make a
NORMAL PROFIT
(P = ATC).
This is similar to
Perfect Competition
MRLR
qLR
q: capacity quantity
Price > MC Price > 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?
Price
Minimum ATC
(Capacity)
PLR
=
ATC
MCLR
MRLR
qLR
M
C
Is the Consumer worse
ATC off in Monopolistic
Competition?
It depends how
consumers feel about
dpc having a variety of goods
to consume...
If value to consumers of
dLRhaving a variety of goods >
(Pmc > Ppc) , then consumers
could be better off in
monopolistic competition
q: capacity quantity
The only way to reach minimum ATC is if the demand curve
faced by the firm is perfectly elastic (only true in perfect
competition)
The reason for the downward sloping demand curve in
monopolistic competition is because of Product Differentiation.
Pmc > Ppc , but if consumers value variety in goods and services
perhaps they are willing to pay the difference.
Monopolistic Competition &
Non-Price competition between firms
• Because product differentiation exists in
monopolistic competition, firms need to make their
product 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 for.
Price
M
C
ATC (with Selling Costs)
ATC(without Selling Costs)
PLR
dLR
MRLR
Selling Costs
and
Monopolistic
Competition
qLR q: capacity quantity
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 Oligopolies
Percent of value of shipment of product
Industry
four
Cigarettes
98.9
Chewing Gum
96
Household Laundry equipment 90
Beer
90
Electric Lamp bulbs
89.7
Cereal breakfast foods
86.7
Motor vehicles
83
Household refrigerators & freezers 82.8
Credit Card Issuing
75.8
College Bookstores
69.5
Motorcycles
63.9
Dog and Cat Food
63.4
Soft Drinks
47.2
eight
100
99
95
94.1
94.7
92
97.6
87.0
73.9
74.7
83.2
58.8
# of firms
9
10
494
54
48
325
21
610
1,839
373
129
388
Oligopoly
Assumptions or characteristics
1. A few large firms that dominate total market share.
2.
Can produce a standardized or
differentiated product
3. 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
categories based on the Oligopolist’s dilemma.
Models where firms compete
Models where firms cooperate
A single firm in the Industry
Kinked Demand
Suppose that firms have already established
an equilibrium
Curve
price for their product
Firms in this industry are
D2 (rival firms don’t match
interested in maintaining or
price increases; elastic)
gaining market share (from
P*
other firms)
What would the demand
curve look like for a firm in
such an industry?
Price
D1(rival firms match price cuts;inelastic)
q*
quantity of chewing gum
• 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)
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
A single firm in the Industry
Kinked Demand
Two implications can
Curve
be found in this model:
If Pd < 1 TR decreases as P decreases
If Pd > 1 TR decreases as P increases
P*
Helps to explain why prices don’t
change often in some oligopolies
q*
quantity of chewing gum
1) This firm has no incentive to change price from the original price.
Any change in price will cause total revenue would decline
2) Costs of production may rise (MC2 > MC1), but the firm may
still keep the same price and quantity.
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 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
Price
Contestable Markets
MC
ATC
PM
MR
qM
Firms in an industry that don’t
have to worry about entry will
maximize profits(MR=MC)
and charge the highest price
they can (PM)
D
quantity
Firms will behave much like a Monopoly
Price
Price
MC
Contestable Markets
MC
ATC
PM
ATC
MR
qM
D
quantity
An Existing firm in a Contestable market
A potential New firm
quantity
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)
Price
Price
MC
Contestable Markets
MC
ATC
PM
ATC
PC
P = Minimum ATC
MR
qM
D
quantity
An Existing firm in a Contestable market
A potential New firm
quantity
To prevent 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).
At that price no potential firm would enter because they could
only earn normal 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
firms 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:
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
(per
barrel)
3) Make sure that no firm exceeds their quota
A single firm in the cartel
MC
$100
$25
qquota
q1
Before a cartel is formed the
price of oil would be $25
ATC This also happens to be
the competitive price...
…so this firm initially
produces the
competitive output at q1
quantity of oil
• Suppose firms in this industry then form a cartel and set a
price to maximize joint monopoly profits.
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
(per
barrel)
3) Make sure that no firm exceeds their quota
A single firm in the cartel
MC
$100
This firm (and all other
firms in the cartel) will
ATC continue to make
economic profit if they
ALL stay within their
quotas
…but each firm in the cartel has
an incentive to cheat to gain
greater economic profit
qquota
q1 qcheat
quantity of oil
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 cheating on it’s
production quota and adding the Peach area to profit(P=MC)
This increase in profit can only work if IT IS THE ONLY
FIRM that cheats (So market price stays at $100)...
Price
(per
barrel)
3) Make sure that no firm exceeds their quota
A single firm in the cartel
MC
$100
$25
qquota
q1 qcheat
…but each firm in the
cartel has an incentive to
ATC cheat to gain greater
economic profit
Since all firms have the
same incentive to cheat, it
is likely enough will cheat
to vastly increase the
supply of the good.
quantity of oil
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 cheating on production
quotas, collusion to raise prices will fail
There is no legal way to prevent cheating, because cartels are
usually illegal in most countries
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.
Here is an example
with two soft
drink firms:
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
3
4
Keep
Quota
Cheat
• 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)
Here is an example
with two soft
drink firms:
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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)
Here is an example
with two soft
drink firms:
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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 strategy
Each firm knows the payoffs that will be received.
Each firm chooses a strategy at exactly the same time.
Game with no
communication
before choosing
strategy
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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
Game with no
communication
before choosing
strategy
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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.
Game where firms
can communicate
before choosing
strategy
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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.
Dilemma: Once this cooperative decision is reached, each firm
is tempted to cheat on the other firm to increase profit...
...and if one firm cheats, it is then in the other firms interest to
cheat as well (End up back in Box 4)
Game where firms
can communicate
before choosing
strategy
Lemons
Limited
Vanilla corporation
Keep Quota
Cheat
1
2
Vanilla profit = $500,000 Vanilla profit = $900,000
Keep
Quota Lemon profit = $500,000 Lemon profit = $100,000
3
Cheat
4
Vanilla profit = $100,000 Vanilla profit = $150,000
Lemon profit = $900,000 Lemon profit = $150,000
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.
Here is an example:
An Entry - Deterrence
Game
Blue.com
Orange
Monopoly
corporationCompetitive price
1
Price
2
Orange: Economic Loss
Enter &
set Price Orange: Economic Loss
Below
Orange’s Blue: Economic Profit Blue:
Price
3
Not
Enter
Economic Loss
4
Orange: Monopoly Profit Orange: Normal Profit
Blue: Normal Profit
Blue:
Normal Profit
Orange is the only firm in a contestable market
If 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 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.
Here is an example:
An Entry - Deterrence
Game
Blue.com
Orange
Monopoly
corporationCompetitive price
1
Price
2
Orange: Economic Loss
Enter &
set Price Orange: Economic Loss
Below
Orange’s Blue: Economic Profit Blue:
Price
3
Not
Enter
Economic Loss
4
Orange: Monopoly Profit Orange: Normal Profit
Blue: Normal Profit
Blue:
Normal Profit
Orange is the only firm in a contestable market
Orange 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
take 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.