1. Chapter 9 Market structure and imperfect competition
©McGraw-Hill Companies, 2010

2. ©McGraw-Hill Companies, 2010
Most markets fall between the 2 extremes of monopoly & perfect competition
An imperfectly competitive firm
would like to sell more at the going price
faces a downward-sloping demand curve
recognises its output price depends on the quantity of goods produced and sold
©McGraw-Hill Companies, 2010 2

3. Imperfect competition
An oligopoly
an industry with few producers
each recognising 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.
©McGraw-Hill Companies, 2010 3

4. ©McGraw-Hill Companies, 2010
Market structure
Competition
Number of Firms
Ability to affect price
Entry Barriers
Example
Perfect
Lots
Nil
None
Fruit stall
Imperfect
Monopolistic
Many
Little
Small
Corner shop
Oligopoly
Few
Medium
Bigger
Cars
Monopoly
One
Large
Huge
Post office
©McGraw-Hill Companies, 2010 4

5. The minimum efficient scale and market demand
The minimum efficient scale (mes) is the output at which a firm’s long-run average cost curve stops falling.
The size of the mes relative to market demand has a strong influence on market structure.
LAC1 D
LAC2
LAC3
Output
©McGraw-Hill Companies, 2010 5

6. 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...
©McGraw-Hill Companies, 2010 6

7. 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. MC AC F
P1=AC1 D MR Q1
Output
©McGraw-Hill Companies, 2010 7

8. ©McGraw-Hill Companies, 2010
Oligopoly
A market with 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.
©McGraw-Hill Companies, 2010 8

9. ©McGraw-Hill Companies, 2010
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 permitted.
e.g. OPEC
©McGraw-Hill Companies, 2010 9

10. 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
©McGraw-Hill Companies, 2010 10

11. The kinked demand curve
Consider how a firm may
perceive its demand curve
under oligopoly. Q0 P0
Quantity
It can observe the current
price and output, but must try to anticipate rival reactions to any price change.
©McGraw-Hill Companies, 2010 11

12. The kinked demand curve (2)
The firm may expect rivals
to respond if it reduces
its price, as this will be seen
as an aggressive move Q0 P0
Quantity D
… so demand in response
to a price reduction is likely
to be relatively inelastic.
The demand curve will
be steep below P0.
©McGraw-Hill Companies, 2010 12

13. The kinked demand curve (3)
… but for a price increase
rivals are less likely to
react, D Q0 P0
Quantity
so demand may be
relatively elastic
above P0
so the firm perceives
that it faces a kinked
demand curve.
©McGraw-Hill Companies, 2010 13

14. The kinked demand curve (4)
Price rises will lead to a large loss of market share. Price cuts increase quantity only by increasing industry sales. D Q0 P0
Quantity
Suppose the firm’s MC curve shifts up or down by a small amount. Since the MR curve has a discontinuous vertical segment at Q0, it remains optimal to leave price unchanged.
Price will tend to be stable, even in the face of changes in marginal cost.
©McGraw-Hill Companies, 2010 14

15. Game theory: some key terms
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
©McGraw-Hill Companies, 2010 15

16. The Prisoners’ Dilemma game
Firm B Output
HIGH
LOW
Firm A Output
The red and blue numbers in each box indicate profits to A and B respectively. Whether B pursues High or Low output, A makes more profit going high, so does B, whatever A adopts. In equilibrium both go high. Yet both would make greater profits if both went low.
©McGraw-Hill Companies, 2010 16

17. 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.
©McGraw-Hill Companies, 2010 17

18. ©McGraw-Hill Companies, 2010
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
©McGraw-Hill Companies, 2010 18

19. Derivation of a firm’s reaction functionD1 p1
QA1
MR1
Assuming firm B produces zero output, A faces the market demand curve D0 and it maximizes profits by setting MR0 = MC and producing QA0.
When B produces some positive output, A faces the residual demand curve D1,sets MR1 = MC and produces QA1. p0 D2 p2
QA2
MR2
When firm B increases its output, A sets MR2 = MC and produces QA2. MC D0
MR0 QB QA RA
The result is the reaction function in the lower panel: the larger the output firm B is expected to sell the smaller is the optimal output of A.
QA0 QA
©McGraw-Hill Companies, 2010 19

20. Nash-Cournot equilibrium
QB* RA E RB 
QA* QB QA
RA and RB are the reaction functions for firms A and B respectively. Each shows the best each firm can do given its expectations about the other
E is the Nash-Cournot equilibrium
At E, each firm’s guess about its rival is correct and neither will wish to change its behaviour
©McGraw-Hill Companies, 2010 20

21. ©McGraw-Hill Companies, 2010
Contestable markets
A contestable market is characterized by free entry and free exit.
no sunk costs
allows hit-and-run entry
Contestability may constrain incumbent firms from exploiting their market power.
©McGraw-Hill Companies, 2010 21

22. 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
©McGraw-Hill Companies, 2010 22

23. ©McGraw-Hill Companies, 2010
Summary
The polar extremes of perfect competition and monopoly are rarely encountered in practice.
Imperfect competition is more the norm.
Economists used to say ‘market structure affects conduct which affects performance’.
©McGraw-Hill Companies, 2010 23

24. ©McGraw-Hill Companies, 2010
Summary (continued)
We now recognise that structure and conduct are determined simultaneously.
Potential competition can have an impact on the behaviour of incumbent firms.
Many business practices can be rationalised as strategic competition.
©McGraw-Hill Companies, 2010 24