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

©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

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

©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

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

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

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

©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

©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

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

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

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

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

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

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

The Prisoners’ Dilemma game Firm B Output HIGH LOW 1 1 3 0 0 3 2 2 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

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

©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

Derivation of a firm’s reaction function £ D1 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

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

©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

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

©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

©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