Lecture 12: Imperfect Competition Readings: Chapters 14,15

The Theory of Supply - Imperfect Competition Q: How relevant are the Perfect Competition and Monopoly models to the real world? A: Very few real world business is carried out in industries which are perfectly competitive or monopolistic. The two most common forms of industrial structure (market structure) are: Monopolistic competition Oligopoly

The Theory of Supply - Imperfect Competition Q: What is Monopolistic competition ? A: It is a market structure where many firms compete through product differentiation — making similar but slightly different products firms have some monopoly (price setting) power because their good does not have a perfect substitute supplied by anyone. entry and exit to the industry is fairly easy.

The Theory of Supply - Imperfect Competition Q: Implications? A: There are several: A monopolistic competitor faces a downward-sloping demand curve in which MR<P To maximize profits, set Q where MC = MR. Profits attract entry by competitors supplying substitutes ® leftward shift demand curve facing each firm Losses cause exit ® rightward shift demand curve facing each firm

Price and Output in Monopolistic Competition The firm in monopolistic competition operates like a single-price monopoly. The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

Price and Output in Monopolistic Competition But a firm might also incur an economic loss in the short run. Here is an example. At the profit-maximizing quantity, P < ATC and the firm incurs an economic loss.

Price and Output in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC). In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.

Price and Output in Monopolistic Competition As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit. Entry and exit shift the demand curve for a firm’s product Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. Explain this effect by sticking with the tennis shoes example. Explain that the demand for Nike tennis shoes changes and the demand curve for Nike tennis shoes shifts if other firms enter or exit. If Tommy Hilfiger and the Gap started to make tennis shoes, some of Nike’s former customers would switch to these two new brands, and the demand for Nike shoes would decrease. The demand curve for Nike shoes would shift leftward. If Adidas, Fila, and Reebok stopped making tennis shoes, some of their former customers would switch to Nike, and the demand for Nike shoes would increase. The demand curve for Nike shoes would shift rightward.

Figure 13.2a Monopolistic Competition: Short Run MC PS QS Economic profit ATC CS MR D Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 291

Figure 13.2b Monopolistic Competition: Long Run PL QL Like Perfect Competition Zero economic profit MR¢ D¢ MC ATC P L > P C P C QC Excess capacity ATC high D Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 291

Price and Output in Monopolistic Competition Figure 14.3 shows a firm in monopolistic competition in long-run equilibrium.

Price and Output in Monopolistic Competition There are two key differences between monopolistic competition and perfect competition are: Excess capacity Markup A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm’s markup is the amount by which its price exceeds its marginal cost.

Price and Output in Monopolistic Competition Firms in monopolistic competition operate with excess capacity in long-run equilibrium. Firms produce less than the efficient scale—the quantity at which ATC is a minimum. The downward-sloping demand curve for their products drives this result.

Price and Output in Monopolistic Competition Firms in monopolistic competition operate with positive markup. Again, the downward-sloping demand curve for their products drives this result.

Price and Output in Monopolistic Competition In contrast, firms in perfect competition have no excess capacity and no markup. The perfectly elastic demand curve for their products drives this result.

The Theory of Supply - Imperfect Competition Q: How would consumers evaluate monopolistic competition and perfect competition? A1: The higher ATC and price of monopolistic competition means less consumer surplus than under perfect competition. A2: On the other hand, monopolistic competition benefits consumers by increasing: product variety; product innovation; and consumer information.

The Theory of Supply - Imperfect Competition Q: Is it possible for an industry to have positive profits in the long-run if it is not a monopoly? A: Firms in an Oligopoly market structure may realize long-run profits. Q: What is an oligopoly? A: It is an industry in which: Only few (large) firms supply the market These firms have price setting power Entry is difficult (barriers to entry)

The Theory of Supply - Imperfect Competition Q: How does the behaviour of firms in an oligopoly differ from firms in other market structures? A: Because of the small number of firms, any action by a competitor will alter a firm’s demand and profit. Firms must anticipate the actions of its competitors, and include competitor actions in their strategies. Because the firms competitors will do the same, the firm must consider the effects of its actions on the behaviour of others. Such interdependence creates a complicated strategic environment.

The Theory of Supply - Imperfect Competition Q: In the absence of strategic interactions, what is the profit maximizing strategy of an oligopoly firm? Choose QS where MR=MC and charge the highest price possible to sell precisely this many units. Q: How can strategic interactions be introduced into the model of a profit maximizing firm? A: There are many models. The earliest and simplest is Stigler’s Kinked Demand curve model.

The Theory of Supply - Imperfect Competition Q: How are strategic interactions introduced in the kinked demand curve model? A: Stigler assumed that firms react to their competitors by adopting a simple rule: match price reductions. ignore price increases. If all firms follow this rule, then each firm expects to face a kinked demand curve, with kink at the current equilibrium P, Q

The Theory of Supply - Imperfect Competition Figure 15.2 shows the kinked demand curve model. The firm believes that the demand for its product has a kink at the current price and quantity.

Two Traditional Oligopoly Models Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.

Two Traditional Oligopoly Models The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure.

Two Traditional Oligopoly Models This slide helps to envisage why the kink in the demand curve puts a break in the marginal revenue curve. The kinked demand curve and discontinuous marginal revenue curve. Students have no trouble with the kinked demand curve, but the discontinuous MR curve needs a bit of explanation. The approach that works best is to extend the lower section of the demand curve to the y-axis and draw its MR curve. Then erase the segment of the demand curve and the associated segment of the MR curve to the left of the kink. If you want to use this explanation, unhide this slide by clicking on Slide Show, Hide Slide.

Two Traditional Oligopoly Models Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged. For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit-maximizing price and quantity would not change.

The Theory of Supply - Imperfect Competition Q: What does the kinked demand curve predict about behaviour in oligopolies? A: sticky prices Small changes in MC will not alter Q or P. Monopolies exhibited price stickiness to changes in FC but not changes in MC.

The Theory of Supply - Imperfect Competition Q: Is the kinked demand model a useful model? A: The model has some fundamental problems: What determines current market P? What determines current market shares? What do firms do if they discover their beliefs are incorrect concerning the strategic behaviour of their competitors. Are profits maximized using this strategic rule? These questions have lead researchers to model the reaction strategy as a choice (rather than a rule).

The Theory of Supply - Imperfect Competition Q: How might we model choice of reaction strategies? A: Game theory attempts to model reaction strategy choices in an environment of strategic interaction. As with other models of firm decision making, the objective guiding the choice is profit maximization. Good models will generate strategy equilibrium which help us understand the observed strategy choices which firms adopt in the real world.

The Theory of Supply - Imperfect Competition Q: How is game theory used to analyze the strategic behaviour of firms in oligopolies? A: A game is defined by specifying: A set of players. A set of strategies available to the players delineating permissible actions by players (such as raising or lowering price, output, advertising, or product quality.) A set of payoffs for each player under each possible combination of strategies taken by all the players.

The Theory of Supply - Imperfect Competition Q: Can a simple model of a ‘game’ provide any deep insight into anything as complex as the strategic between the world’s most powerful companies? A: The "Prisoners' dilemma" is one-time, two-person game that provides surprising answers to a huge number of situations in which there are strategic interactions. continued

The Theory of Supply - Imperfect Competition Q: What is the Prisoner’s dilemma game? A: The game is defined as: Players: Art and Bob Strategies: Each player is accused of a crime. Each player may choose to either confess or deny. Payoffs: The expected payoff for each player under all possible strategy combinations can be summarized in a payoff matrix.

Oligopoly Games Be sure the students know how to read the payoff matrix. Explain that Art’s payoff from each combination of actions is shown in the top of each payoff box, and Bob’s is shown as the bottom of each payoff box. Note that there are four possible outcomes: Bob and Art both confess (top left box), both Bob and Art deny (bottom right box), Bob confesses but Art does not (top right box), and Art confesses but Bob does not (bottom left box).

The Theory of Supply - Imperfect Competition Each player’s dominant strategy is to confess. It is a dominant strategy for Art to confess, because confessing is Art’s best response to both of Bob’s strategies. Similarly it is a dominant strategy for Bob to confess. John Nash also suggested that Bob Confess – Art Confess is an equilibrium strategy combination in the sense that neither players has an incentive to deviate from their strategy given the other player’s action.

Bob’s view of the world Explain that we’re first going to look at Bob’s thought experiment. He first asks: suppose that Art confesses. What should I do? The answer is confess and get 3 years. If I deny, I get 10 years.

Bob’s view of the world He next asks: suppose that Art denies. What should I do? The answer is confess and get 1 year. If I deny, I get 2 years.

Art’s view of the world Go on to explain that Art is sitting in his cell pondering the same questions. He asks: suppose that Bob confesses. What should I do? The answer is confess and get 3 years. If I deny, I get 10 years.

Art’s view of the world He then asks: suppose that Bob denies. What should I do? The answer is again confess and get 1 year. If I deny, I get 2 years.

Equilibrium We’ve seen that both confess regardless of what the other does. The equilibrium is for both to confess. Note that this outcome is called a dominant strategy equilibrium. Also, emphasize that this outcome is not the best one. If the players could have cooperated (communicated and committed) they would have chosen to deny and each get 2 years.

The Theory of Supply - Imperfect Competition New Concepts: dominant strategy — unique best strategy independent of other player's action dominant strategy equilibrium — occurs when dominant strategy for each player Nash equilibrium — A’s strategy is the best response to B’s strategy and B’s strategy is the best response to A’s strategy

The Theory of Supply - Imperfect Competition Q: What does this model tell us about strategic interaction? A: It explains police behaviour in questioning suspects: Keep suspects apart Suggest the other suspect is ratting him out Offer both suspects a plea bargain

The Theory of Supply - Imperfect Competition Q: Does the model help us understand the behaviour of large firms in an oligopoly industry? A: The model explains why collusive price fixing agreements often fall apart. Consider a Duopoly (oligopoly with two firms). Each firm (Gear & Trick) can compete or collude. Competition will reduce prices and profits. Collusion will allow them to behave like a monopolist and raise prices and profits.

The Theory of Supply - Imperfect Competition Part (a) shows each firm’s cost curves. Part (b) shows the market demand curve.

The Theory of Supply - Imperfect Competition This industry is a natural duopoly. Two firms can meet the market demand at the least cost.

The Theory of Supply - Imperfect Competition Q: How does this market work? A: If they compete: P = 6 and Q = 6 in equilibrium

The Theory of Supply - Imperfect Competition Q: Can they do better? A: Yes if the two firms enter into a collusive agreement in which they plan to restrict output, raise the price, and increase profits. Such agreements are illegal in the Canada and the United States and are undertaken in secret. Firms in a collusive agreement operate a cartel.

The Theory of Supply - Imperfect Competition Firms in a cartel act like a monopoly to maximize economic profit.

The Theory of Supply - Imperfect Competition To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel.

The Theory of Supply - Imperfect Competition The cartel’s marginal cost curve is the horizontal sum of the MC curves of the two firms and the marginal revenue curve is like that of a monopoly.

The Theory of Supply - Imperfect Competition The firm’s maximize economic profit by producing the quantity at which MCI = MR.

The Theory of Supply - Imperfect Competition Each firm agrees to produce 2,000 units and each firm shares the maximum economic profit. The blue rectangle shows each firm’s economic profit.

The Theory of Supply - Imperfect Competition When each firm produces 2,000 units, the price is greater than the firm’s marginal cost, so if one firm increased output, its profit would increase.

The Theory of Supply - Imperfect Competition Suppose one firm cheats on a collusive agreement. The cheat increases its output to 3,000 units. Industry output increases to 5,000 and the price falls.

The Theory of Supply - Imperfect Competition For the complier, ATC now exceeds price. For the cheat, price exceeds ATC.

The Theory of Supply - Imperfect Competition The complier incurs an economic loss. The cheat makes an increased economic profit.

The Theory of Supply - Imperfect Competition Suppose that both firms cheat and increase their output to 3,000 units.

The Theory of Supply - Imperfect Competition Industry output is 6,000 units, the price falls, and both firms make zero economic profit—the same as in perfect competition.

The Theory of Supply - Imperfect Competition The strategies that firms in a cartel can pursue are to Comply Cheat Because each firm has two strategies, there are four possible combinations of actions for the firms: 1. Both comply. 2. Both cheat. 3. Trick complies and Gear cheats. 4. Gear complies and Trick cheats.

The Theory of Supply - Imperfect Competition Possible Outcomes If both comply, each firm makes $2 million a week. If both cheat, each firm makes zero economic profit. If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million. If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million.

Payoff Matrix

Trick’s view of the world Tell the story in the same way as for the prisoner’s dilemma.

Trick’s view of the world

Gear’s view of the world

Gear’s view of the world

Equilibrium

The Theory of Supply - Imperfect Competition Nash Equilibrium in Duopolists’ Dilemma The Nash equilibrium is that both firms cheat. The quantity and price are those of a competitive market, and the firms make zero economic profit. The R&D Game. This example really happened. You can flesh out the time line of developments in this industry at http://www.gpoabs.com.mx/cricher/timeline.htm.

The Theory of Supply - Imperfect Competition Q: Is this a realistic model? A: There are numerous examples: OPEC1974, OPEC1980, OPEC2001 Joe Smith’s secret contract with the Minnesota Timberwolves Q: If it is so difficult how can firms collude? A: They attempt to bind themselves to contracts.

The Theory of Supply - Imperfect Competition Q: Are collusive contracts possible? A: Generally no! It is illegal to enter into collusive arrangements. Q: Are there exceptions? A: There are two exceptions: Professional sports leagues are exempt, and may pursue collusive arrangements. It is not against international law enter into a collusive agreement. continued

The Theory of Supply - Imperfect Competition Q: Should we be worried? A: Perhaps. Secret agreements may be supported as an equilibrium in repeated games. The incentive to cheat is reduced when players adopt dynamic strategies such as: tit-for-tat — take the same action as the other player took in the last period trigger — cooperate until the other player cheats, then respond by cheating forever

The Theory of Supply - Imperfect Competition Game theory can be used to analyze other choices facing firms how much to spend on research and development how much to spend on advertising whether to enter or exit an industry continued

The Theory of Supply - Imperfect Competition Q: How much power do firms in oligopolies have? A: It depends on the cost of entry to the industry: If a firm is in a Contestable market, then entry and exit are relatively cheap. Incumbent firms must not raise price much above the competitive market price, or else a new firm may enter the industry, increase output and reduce prices. The threat of entry keeps prices closer to the competitive market price than the monopoly price.

The Theory of Supply - Imperfect Competition Figure 15.8 shows the game tree for a sequential entry game in a contestable market.

The Theory of Supply - Imperfect Competition In the first stage, Agile decides whether to set the monopoly price or the competitive price.

The Theory of Supply - Imperfect Competition In the second stage, Wanabe decides whether to enter or stay out.

The Theory of Supply - Imperfect Competition In the equilibrium of this entry game, Agile sets a competitive price and makes zero economic profit to keep Wanabe out. A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out.

The Theory of Supply - Imperfect Competition Q: Can firms in an oligopoly protect aggressively deter entry even if the costs of entry are low? A: There are a number of entry deterring strategies. The most famous is Predatory pricing (i.e. Air Canada). Q: When will oligopoly behave like a monopoly? A: When entry costs are high, or when entry deterring strategies are effective.

Anti-Combine Law To protect against collusion most countries have enacted anti-combine or anti-trust legislation 1889 - Canada’s first anti-combine law 1986 - the Competition Act of 1986. The 1986 Act established a Competition Bureau and a Competition Tribunal. The Act distinguishes between criminal and noncriminal practices.

Anti-Combine Law Criminal practices include Conspiracy to fix prices Bid-rigging False advertising Non-Criminal practices include Mergers Abuse of dominant position Exclusive dealing

Anti-Combine Law Some Major Anti-Combine Cases NutraSweet tried to gain a monopoly in aspartame (non-sugar sweetener) by licensing the use of its “swirl” only on products for which it had an exclusive deal. Bell Canada Enterprises tried to tie the sale of advertising space in the Yellow Pages to the sale of advertising services from one of its own subsidiaries.

Anti-Combine Law Other Recent Cases Cineplex Galaxy Famous Players merge allowed. Bank merger between Royal Bank and Bank of Montreal and merger between CIBC and TD Bank were blocked. Gasoline price-fixing cartel in Quebec investigated and fined more than $2 million. NHL cleared of anticompetitive policies.

End of Lecture 12