1. Chapter 11: Imperfect Competition and Strategic Behaviour
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2. Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
11.1 The Structure of the Canadian Economy
recognize that Canadian industries typically have either a large number of small firms or a small number of large firms.
11.2 What Is Imperfect Competition?
explain why imperfectly competitive firms have differentiated products and often engage in non-price competition.
11.3 Monopolistic Competition
describe the key elements of the theory of monopolistic competition.
11.4 Oligopoly and Game Theory
understand why strategic behaviour is a key feature of oligopoly.
11.5 Oligopoly in Practice
use game theory to explain the difference between cooperative and non-cooperative outcomes among oligopolists.
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Chapter 11, Slide

3. Imperfect Competition
LO1
A market structure in which producers are identifiable and have some control over price
Two forms:
Monopolistic Competition
Oligopoly
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4. 11.1 The Structure of the Canadian Economy
Industries with Many Small Firms
The perfectly competitive model does not adequately explain many industries that have a large number of relatively small firms.
Monopolistic competition studies the behaviour and the outcomes in industries with many small firms, each with some market power.
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5. Industries with a Few Large Firms
Most modern industries that are dominated by large firms contain several firms. These are not competitive markets. The theory of oligopoly helps us understand industries with few large firms, each with market power, that compete actively with each other.
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6. Industrial Concentration
The concentration ratio measures economic power in an industry and shows the market shares of the largest four or eight producers. Defining a market with reasonable accuracy is difficult. Sometimes the market is much smaller than the whole country. Other times, it is much larger than the entire country.
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7. Measuring Industry Concentration
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
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8. Fig. 11-1 Concentration Ratios in Selected Canadian Industries
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9. 4 Firm Concentration Ratios
LO2
Industry
1990
2005
Motor Vehicles
87.2%
100.0%
Petroleum
75.6
99.9
Tobacco
98.8
99.8
Cement
72.0
99.7
Fertilizers
56.7
99.4
Tires
86.2
99.3
Breweries
90.6
99.2
Sugar and Confectionary
47.8
98.7
Household Appliances
61.6
98.5
Coffee and Tea
76.5
97.8
Sporting and Athletic Goods
22.7
92.8
Wineries
48.5
92.2
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10. Self-Test The grummit industry consists of 10 companies. Company
LO2
The grummit industry consists of 10 companies.
Company
Sales $m: A
$22 B $6 C
$17 D
$12 E $8 F
$15
Next 4 (total)
Calculate the 4-firm concentration ratio for this industry.
What type of market does this industry operate in?
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11. 11.2 What Is Imperfect Competition?
Firms Choose Their Products
A differentiated product: a group of products that are similar enough to be called the same product but different enough that they can have different prices.
Most firms in imperfectly competitive markets sell differentiated products:
laundry soaps, beer, cars, running shoes
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12. Firms Choose Their Prices
Typically, firms are price setters. Often, these prices vary only slowly over time. Firms often let output vary in response to demand shocks to avoid costs of changing prices (unless the shock is long-lasting).
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13. Non-Price Competition
Imperfectly competitive firms typically engage in behaviour that is absent in either monopoly or perfect competition:
firms often spend large sums of money on advertising
firms often engage in non-price competition
firms may create entry barriers to prevent erosion of current pure profits
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14. Two Market Structures
The preceding discussion applies in general to imperfectly competitive market structures.
Industries with a large number of small firms— the theory of monopolistic competition.
Industries with a small number of large firms— the theory of oligopoly (which involves game theory).
A key difference: strategic behaviour displayed by firms.
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15. 11.3 Monopolistic Competition
The Assumptions of Monopolistic Competition
Each firm produces one variety of the differentiated product. Thus, it faces a negatively sloped and highly elastic demand curve.
All firms have access to the same technology and thus have the same cost curves.
The industry contains so many firms that each one ignores competitors when making price and output decisions.
Firms are free to enter and exit the industry.
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16. Empirical Relevance of Monopolistic Competition
The theory of monopolistic competition is useful for analyzing industries with low concentration ratios and differentiated products:
Restaurants
Clothing
Hair stylists
Mechanics
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17. Predictions of the Theory
Fig. 11-2(i) Profit Maximization for a Firm in Monopolistic Competition
In the short run, a monopolistically competitive firm faces a downward sloping demand curve and maximizes profits by equating MR and MC.
In the short run it is possible for the firms to make positive profits, break even, or even to make losses.
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18. Predictions of the Theory
Fig. 11-2(ii) Profit Maximization for a Firm in Monopolistic Competition
This firm is earning positive profits.
an incentive for new firms to enter the industry.
the existing market demand must be shared among a larger number of firms.
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19. Fig. 11-2(i) Profit Maximization for a Firm in Monopolistic Competition
As new firms enter, profits per firm are reduced, and eventually eliminated. In the LR equilibrium, each firm has excess capacity. This result is often called the excess-capacity theorem of monopolistic competition.
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20. Predictions of the Theory
In contrast to perfect competition, the LR equilibrium in monopolistic competition does not minimize ATC— there is excess capacity. This excess capacity may not be wasteful if consumers value product variety. Society faces a tradeoff between product variety and lower cost per unit.
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21. 11.4 Oligopoly and Game Theory
Oligopoly: an industry containing two or more firms, at least one of which produces a significant portion of the industry's total output. An oligopolistic firm faces only a few competitors.  Strategic behaviour is central to their actions.
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22. Characteristics Oligopoly It is dominated by a few large firms.
LO4
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.
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23. Mutual interdependence
Oligopoly
LO4
Mutual interdependence
the condition in which a firm’s actions depend, in part, on the reactions of rival firms
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24. The Basic Dilemma of Oligopoly
Oligopolistic firms will make more joint profits if they cooperate, or collude. But each individual firm may make more profits if it "cheats." How could firms reach a cooperative outcome to maximize their joint profits? Game theory is used to study decision making in such situations— each player takes account of the others' expected reactions when making a move.
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Chapter 11, Slide

25. Collusion
LO5
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
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26. Some Simple Game Theory
Game theory: the theory that studies decision making in situations in which one player anticipates the reactions of other players to its own actions.
When game theory is applied to oligopoly:
the players are firms.
their game is played in the market.
their strategies are their prices or output decisions.
the payoffs are their profits.
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Chapter 11, Slide

27. Consider a simplified duopoly in which two firms choose to cooperate or compete: Cooperate: produce 1/2 of the monopoly output — yields low output and high price Compete: produce 2/3 of the monopoly output — yields high output and low price
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28. The payoff matrix for this game:
Fig The Oligopolist's Dilemma: To Cooperate or to Compete?
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29. A Nash equilibrium is an outcome in which each firm is doing the best it can given what the other firm is doing. Note that for each firm, the best action is to "compete," no matter what the other firm is doing. So in this game, the Nash equilibrium has both firms "competing" and producing the higher level of output.
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30. Fig. 11-3 The Oligopolist's Dilemma: To Cooperate or to Compete?
Cooperative Equilibrium
Nash Equilibrium
But notice that the Nash equilibrium does not maximize joint profits —this is the classic example of the prisoners' dilemma!
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31. EXTENSIONS IN HISTORY 11-1
The basis of a Nash equilibrium is rational decision making in the absence of cooperation. Once in a Nash equilibrium, no firm has an incentive to unilaterally alter its own behaviour.
EXTENSIONS IN HISTORY 11-1
The Prisoners' Dilemma
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32. Self-Test
LO5
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?
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33. Extensions in Game Theory
The simple game described applies to oligopolists producing identical products.
Game theory can be used in other settings:
how firms interact when they charge different prices for their differentiated products.
how firms interact when the decision is whether to develop a new product.
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Chapter 11, Slide

34. Types of Cooperative Behaviour
11.5 Oligopoly in Practice
The simple game described applies to oligopolists producing identical products.
Types of Cooperative Behaviour
When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion.
explicit collusion occurs when firms formally agree—DeBeers and OPEC
cooperation without explicit agreement is called tacit collusion.
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35. Explicit Cooperation in OPEC
LESSONS FROM HISTORY 11-1
Explicit Cooperation in OPEC
Types of Competitive Behaviour
firms may compete for market share
firms may offer secret discounts to increase sales
firms may use innovation and attempt to gain advantage over rivals in the very long run
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36. The Importance of Entry Barriers
In the absence of natural entry barriers, oligopolistic firms must create entry barriers if they are to earn profits in the long run.
Brand Proliferation as an Entry Barrier
A large number of differentiated products leaves small market share available to a new firm.
This is one explanation for many varieties of a product being produced by the same firm.
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Chapter 11, Slide

37. Advertising as a Barrier to Entry
Heavy advertising can force an "outside" firm to spend heavily on its own advertising. If the "outside" firm had a low MES, the new advertising costs may result in a much higher MES  deters entry.
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38. Predatory Pricing
A firm will not enter a market if it expects continued losses after entry. Existing firms can create such an expectation by keeping prices below their own costs until the entrant goes bankrupt. The existing firm loses profits, but it also discourages potential future rivals.
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39. Oligopoly and the Economy
Temporary changes in demand lead to more price volatility in competitive markets than in oligopoly markets. Permanent changes in demand, however, lead to similar adjustments in both market structures. Oligopoly is an important market structure in modern economies because there are many industries in which the MES is simply too large to support many competing firms.
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Chapter 11, Slide

40. Oligopolists often grow through mergers or by driving rivals into bankruptcy. This process increases the size and market share of survivors, and possibly reduces the extent of competition in the market. The challenge for public policy is to keep oligopolies competing and using their competitive energies to improve products and reduce costs.
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