SAYRE | MORRIS Seventh Edition Imperfect Competition CHAPTER © 2012 McGraw-Hill Ryerson Limited Alanna Holowinsky, Red River College

Imperfect Competition Learning Objectives: LO1: Understand the importance and effects of product differentiation, including advertising LO2: Understand the differences between the two types of imperfect competition LO3: Explain why monopolistically competitive firms tend to have excess capacity and are unlikely to earn long-run economic profits CHAPTER © 2012 McGraw-Hill Ryerson Limited

Imperfect Competition Learning Objectives: LO4: understand the main characteristics of oligopoly markets LO5: understand why large firms are often tempted to collude and form cartels LO6: understand price leadership and why oligopolistic firms are reluctant to change prices very often CHAPTER © 2012 McGraw-Hill Ryerson Limited

Imperfect Competition A market structure in which producers are identifiable and have some control over price Two forms: 1.Monopolistic Competition 2.Oligopoly 11-4© 2012 McGraw-Hill Ryerson Limited LO1

Imperfect Competition Product Differentiation Attempt to distinguish a firm’s products from those of its competitors Firms often compete on basis other than price Logos, symbols, brand names, location, service, product development Often involves extensive advertising 11-5© 2012 McGraw-Hill Ryerson Limited LO1

Advertising Benefits of Advertising Provides the consumer with vital information Enhances competition between firms Lowers the prices of products Finances magazines and television shows 11-6© 2012 McGraw-Hill Ryerson Limited LO1

Advertising Criticisms of Advertising Mostly not informative and wasteful Encourages concentration within industries Raises prices to the detriment of consumers 11-7© 2012 McGraw-Hill Ryerson Limited LO1

Self-Test Assume that two firms dominate the running-shoes industry. One of them hires a high-profile sports figure to endorse its product by appearing in its advertising. a)What would you expect the other firm to do in response, and why? b)After the second firm has reacted in the way you said it would above, what do you think the relative share of the market that each firm enjoyed would be? c)Given your answer in b) above, what might these two firms be tempted to do? 11-8© 2012 McGraw-Hill Ryerson Limited LO1

Self-Test Assume that two firms dominate the running-shoes industry. One of them hires a high-profile sports figure to endorse its product by appearing in its advertising. a)What would you expect the other firm to do in response, and why? 11-9© 2012 McGraw-Hill Ryerson Limited LO1 Game theory analysis suggests that the other firm would be forced to respond with a new advertising campaign possibly using another high profile sports figure.

Self-Test Assume that two firms dominate the running-shoes industry. One of them hires a high-profile sports figure to endorse its product by appearing in its advertising. b)After the second firm has reacted in the way you said it would above, what do you think the relative share of the market that each firm enjoyed would be? 11-10© 2012 McGraw-Hill Ryerson Limited LO1 Relative market share between the two firms probably would not change much from what it was initially.

Self-Test Assume that two firms dominate the running-shoes industry. One of them hires a high-profile sports figure to endorse its product by appearing in its advertising. c)Given your answer in b) above, what might these two firms be tempted to do? 11-11© 2012 McGraw-Hill Ryerson Limited LO1 The two firms would be tempted to come to an (illegal) agreement avoiding expensive adverting campaigns in the future.

Types of Imperfect Competition Monopolistic Competition a market in which many firms sell a differentiated product and have some control over price Oligopoly a market dominated by a few large firms 11-12© 2012 McGraw-Hill Ryerson Limited LO2

Measuring Industry Concentration Concentration Ratio The percentage of an industry’s total sales that is controlled by the largest few firms 4-firm concentration ratio: % of sales revenue by 4 largest firms in industry If < 40% may be monopolistic competition If > 40% likely oligopoly 11-13© 2012 McGraw-Hill Ryerson Limited LO2

4 Firm Concentration Ratios 11-14© 2012 McGraw-Hill Ryerson Limited LO2

Self-Test The grummit industry consists of 10 companies. CompanySales $m: A $22 B $6 C $17 D $12 E $8 F $15 Next 4 (total) $ © 2012 McGraw-Hill Ryerson Limited LO2 a)Calculate the 4-firm concentration ratio for this industry. b)What type of market does this industry operate in?

Self-Test The grummit industry consists of 10 companies. CompanySales $m: A $22 B $6 C $17 D $12 E $8 F $15 Next 4 (total) $ © 2012 McGraw-Hill Ryerson Limited LO2 a)Calculate the 4-firm concentration ratio for this industry. b)What type of market does this industry operate in? 71.7% ($66/$92) Oligopoly (it is higher than the 40%)

Monopolistic Competition Characteristics Many small firms acting independently Freedom of entry Products are differentiated Each firm has some control over price 11-17© 2012 McGraw-Hill Ryerson Limited LO3

Monopolistic Competition May have economic profit in the short run In the long run, the representative firm in a monopolistically competitive market makes only normal profits 11-18© 2012 McGraw-Hill Ryerson Limited LO3

Monopolistically Competitive Equilibrium (SR) 11-19© 2012 McGraw-Hill Ryerson Limited LO2

Monopolistically Competitive Equilibrium (SR) 11-20© 2012 McGraw-Hill Ryerson Limited LO2

Self-Test Assume that a representative firm in monopolistic competition is experiencing economic losses. What series of events will occur to return this firm to its long-run equilibrium? 11-21© 2012 McGraw-Hill Ryerson Limited LO2

Self-Test Assume that a representative firm in monopolistic competition is experiencing economic losses. What series of events will occur to return this firm to its long-run equilibrium? 11-22© 2012 McGraw-Hill Ryerson Limited LO2 Some firms within the industry will go out of business (exit). Graphically, this would shift the demand curve faced by each of the remaining firms to the right so that it once again became tangent to the average cost curve.

11-23© 2012 McGraw-Hill Ryerson Limited LO2

Appraisal of Monopolistic Competition produces a lower output than a perfectly competitive firm does not achieve productive efficiency because the long-run equilibrium price does not equal minimum average total cost charges a higher price than a perfectly competitive firm does not achieve allocative efficiency because price exceeds marginal cost 11-24© 2012 McGraw-Hill Ryerson Limited LO3

Self-Test a)What output will this firm produce? b)How much excess capacity exists at this output level? 11-25© 2012 McGraw-Hill Ryerson Limited LO3

Self-Test a)What output will this firm produce? b)How much excess capacity exists at this output level? 11-26© 2012 McGraw-Hill Ryerson Limited LO3 Q2. (where MC=MR.) Excess capacity of Q4 – Q2

Oligopoly Characteristics It is dominated by a few large firms. Entry by new firms is difficult. Nonprice competition between firms is widely practised. Each firm has significant control over its price. Mutual interdependence exists between firms. Products can be either homogeneous or differentiated © 2012 McGraw-Hill Ryerson Limited LO4

Oligopoly Mutual interdependence the condition in which a firm’s actions depend, in part, on the reactions of rival firms 11-28© 2012 McGraw-Hill Ryerson Limited LO4

Collusion an agreement among suppliers to set the price of a product or the quantities each will produce Game Theory a method of analyzing firm behaviour that highlights mutual interdependence among firms 11-29© 2012 McGraw-Hill Ryerson Limited LO5

Game Theory Nash Equilibrium a situation where each rival chooses the best actions given the (anticipated) actions of the other(s) 11-30© 2012 McGraw-Hill Ryerson Limited LO5

Game Theory 11-31© 2012 McGraw-Hill Ryerson Limited LO5

Collusive Oligopoly Cartel an association of sellers acting in unison for example, Organization of Petroleum Exporting Countries (OPEC) able to increase prices by restricting output cartels work to the advantage of their members only if there is no cheating among the participants 11-32© 2012 McGraw-Hill Ryerson Limited LO5

Self-Test Suppose that Spartan Inc. and Trojan Ltd, the only two firms in the industry, have entered into a collusive agreement to share the industry’s total profits of $50 million equally. However, if any one of them cheats, it will increase its profits by $10 million at a cost of $10 million to the other firm. If they both cheat, they will each reduce their profits by $5 million. a)Construct a matrix showing the various options. b)Which option will they likely chose? 11-33© 2012 McGraw-Hill Ryerson Limited LO5

Self-Test a)Construct a matrix showing the various options. b)Which option will they likely chose? 11-34© 2012 McGraw-Hill Ryerson Limited LO5 Cell D. They will end up both cheating.

Noncollusive Oligopoly Price Leadership When rival firms engage in what amounts to price fixing without overt collusion A leader – usually the largest or most efficient firm – sets price, other firms follow Must balance the advantages of a price increase with the risks of creating an opening for new entrants 11-35© 2012 McGraw-Hill Ryerson Limited LO6

© 2012 McGraw-Hill Ryerson Limited LO6

© 2012 McGraw-Hill Ryerson Limited LO6

Oligopoly Some believe that oligopolies are too powerful and produce inefficiently Others take the view that oligopolies are at the cutting edge of new technological development and, in the long run, push the average costs of production down 11-38© 2012 McGraw-Hill Ryerson Limited LO6

Key Concepts to Remember: The importance of product differentiation The two types of imperfect competition – monopolistic competition and oligopoly Collusion and cartels Price leadership CHAPTER 11 SUMMARY 11-39© 2012 McGraw-Hill Ryerson Limited