1. Introductory Microeconomics (ES10001)
Topic 5: Imperfect Competition

2. I. Introduction PC & Monopoly are useful benchmarks.
But, in more than half of the 800 major UK manufacturing product categories, 70% of market is shared by 5 largest firms in the market.
Real world markets are imperfectly competitive
Imperfectly competitive (IC) firms cannot sell as much as want at going market price; they face a downward sloping demand curve.

3. I. Introduction Two models of imperfect competition
Monopolistic Competition
Oligopoly
And in terms of Oligopoly
Non-Collusive
Collusive

4. II. Monopolistic Competition
Theory originally developed by Chamberlain (USA) and Robinson (UK) in early 1930s
Many sellers producing similar, but not identical, products that are close substitutes for each other
Each firm has only a limited ability to affect the market price

5. II. Monopolistic Competition
Assumptions:
Large number of small firms; firms assume own behaviour has no influence on rivals actions;
Similar, but not identical, products;
Free entry and exit into industry

6. II. Monopolistic Competition
Implication
Each firm can, to some extent, influence its market share by changing its price relative to its competitors
Demand curve is downward sloping because different firms’ products are only limited substitutes for each other
Advertising; product differentiation

7. II. Monopolistic Competition
Short-run equilibrium of typical monopolistically competitive firm
Profit-maximising monopolist in its own brand
Thus MR = MC and (we assume) profit > 0

8. Figure 1: Monopolosit Competition (SR)
π > 0 p
SMC p0
SAC
Profit
LAC0
D = AR MR Q Q0

9. II. Monopolistic Competition
Existence of supernormal profit induces other firms to enter industry with their own brands
This shifts down/left demand curve facing existing monopolistically competitive firms
Moreover, demand curve becomes more elastic since consumers now have a greater variety of choice
Process continues until no more firms enter industry (i.e. all firms are earning normal profit)

10. Figure 2: Impact on AR of entry of rival brandsQ

11. Figure 3: Monopolist LR Equilibrium π = 0 p
LMC
LAC
p0 = LAC0
D = AR MR Q Q0

12. II. Monopolistic Competition
Long-run tangency equilibrium where p = LAC
Monopolistically competitive firms are neither electively nor productively efficient
‘... too many firms each producing too little output.’ (Chamberlain)
But …
‘... excess capacity is the cost of differentness.’ (Chamberlain).

13. III. Oligopoly ‘Competition among the few’
Few producers, each of whom recognises that its own price depends on both its own output and the output of its rivals
Thus, firms are of a size and number that each must consider how its own actions affect the decisions of its relatively few competitors.
For example, firm must consider likely response of rivals before embarking on a price cutting strategy

14. III. Oligopoly Collusion or competition?
Key element of all oligopolistic situations
Collusion; agreement between existing firms to avoid competition with one another
Can be explicit or implicit

15. III. Oligopoly
For example, existing firms might collude to maximise joint profits by behaving as if they were a multi-plant monopolist
i.e. restricting q to monopolist level, say q0, and then negotiating over the division of q and monopoly profits
Note, might not agree to divide up q equally; sensible for more efficient members of the cartel to produce q

16. Figure 4: Collusion or Competition pMC MR
D = AR q
q q1

17. III. Oligopoly
But, since cartel p > MC, each firm has an incentive to renege on the collusive agreement
... temptation to reach the ‘first best’ renders the ‘second best’ unsustainable and drives firms to ‘third best’
First-Best: I renege, you collude
Second-Best: Neither renege; we both collude
Third-Best: We both renege
Cartels are inherently fragile!

18. Figure 4: Collusion or Competition p
Cartel price is above cartel member’s marginal cost, thus incentive to renege (i.e. increase q) p0
Normal profit equilibrium p1 MC MR
D = AR q
q q1

19. III. Oligopoly
Collusion is easiest when formal agreements between firms are legally permitted (e.g. OPEC).
More common in 19th century, but increasingly outlawed
Collusion is more difficult the more firms there are in the market, the less the product is standardised, and the more demand and cost conditions are changing in the absence of collusion

20. III. Oligopoly
In absence of collusion, each firm’s demand curve depends upon how competitors react, and firms have to make assumptions about this
A simple model of this was developed by Sweezy (1945) to explain that apparent fact that prices once set as a mark-up on average costs, tend not too change
‘Kinked Demand Curve’ model

21. III. Oligopoly
Assume firm is at E0 selling q0 output at a unit price of p0
Firm believes that if it raises price, its rivals will not raise their price (i.e. DA), but that if it lowers price, then its rivals will follow him (i.e. DB)
Thus demand curve is kinked at E0 being flatter for p > p0 and steeper for p < p0

22. Figure 5a: Kinked Demand Curve Model pDA DB q q0

23. III. Oligopoly
Both the ‘no-follow’ demand curve (DA) and the ‘follow’ demand curve (DB) will have an associated MR curve (MRA, MRB)
Thus MR is discontinuous (i.e. vertical) at q0 since an increase in q beyond q0 will lead to a discontinuous fall in total revenue

24. Figure 5b: Kinked Demand Curve Model pDA DB q q0
MRA
MRB

25. Figure 5c: Kinked Demand Curve Model pq q0 MR

26. III. Oligopoly
Thus, fluctuations in marginal cost within the discontinuous part of the MR curve (i.e. within A-B) do not lead to a change in the firms profit-maximising level of output
Sweezy used the model to model the inflexibility of US agricultural prices in the face of cost changes

27. Figure 5a: Kinked Demand Curve Model p
LMC E0 p0 A B D q q0 MR

28. III. Oligopoly But two key weaknesses: Empirical
Further evidence suggested that agriculture prices did not behave asymmetrically
Theoretical
Model does not explain how we got to the initial equilibrium, or where we go if LMC moves outside of the discontinuity

29. III. Oligopoly Cournot (1833)
Firms compete over quantities with ‘conjectural variation’ that other firm(s) will hold their output constant
Cournot originally envisaged two firms producing identical spring water at zero cost

30. III. Oligopoly
Two firms (a, b) costlessly produce identical spring water
Assume (normal) demand curve for spring water is:
qd = 100 – 5p
Assume that firm a believes that firm b will produce zero output (i.e. Ea{qb}= 0); firm a’s optimal q is that which maximises firm a’s total revenue vis.

31. Figure 6a: Cournot Competition
Firm a’s optimal output if Ea{qb}= 0 p 20
Ea1 10
D = AR 50
100 q MR

32. III. Oligopoly
However, if firm a were to produce 50 units, then firm b would presume that it (i.e. firm b) faces a (residual) demand curve of:
i.e. a residual demand given by the market demand for the good less firm a’s output
And firm b would make its optimal choice of output accordingly

33. Figure 6b: Cournot Competition
Firm a’s supply Firm b’s (residual) demand 20 10
Ea1
D´ = AR´ 50 q
100 MR
MR´

34. Figure 6c: Cournot Competition
Firm b’s residual demand p 10
Eb2 5
D = AR 25 q 50 MR

35. III. Oligopoly
Thus, if qa = 50, then firm b would maximise its profit (i.e. revenue) by setting qb = 25
But this would imply that firm a would want to change its initial level of output; i.e. qa = 50 was optimal under the assumption that qb = 0
But now that qb = 25, firm a will want to revise its choice of q accordingly

36. III. Oligopoly
Thus, firm a will choose the level of output that maximises total revenue given qb = 25
Firm a’s residual demand curve is thus:
Such that

37. Figure 6d: Cournot Competition
Firm a’s residual demand p 15
Ea2
7.5
D = AR
37.5 q 75 MR

38. III. Oligopoly
This process will continue until neither firm ‘regrets’ its optimal choice of output
i.e. until its ‘conjectural variation’ regarding the other firm’s response is validated
The Cournot equilibrium is thus where:
qa = = qb

39. Figure 6d: Cournot Competition
Cournot Equilibrium p 20 Ei Ej
D = AR q
100
MR MR´

40. III. Oligopoly Cournot market shares Round 1 2 3 4 n Firm a 50 37.5
33.33
Firm b 25
31.25

41. III. Oligopoly
It can be shown that total (i.e. market) equilibrium output under Cournot competition is given by:
where qc is the perfectly competitive level of output (i.e. where p = MC)
N.B. Usually termed ‘Nash-Cournot’ equilibrium, hence superscript ‘n’

42. III. Oligopoly Monopoly n = 1 qn = (1/2)qc Duopoly n = 2 qn = (2/3)qc
Perfect Competition
n = qn = qc

43. III. Oligopoly
Cournot originally envisaged his model in term of sequential decision making on the part of firms
But it would irrational for each firm to persist with the conjectural variation that its rival will hold output constant when they only do so in equilibrium
Moreover, the model implies the existence of a future, in which case it can be shown that profitable collusion is sustainable

44. III. Oligopoly
Economists have re-interpreted Cournot’s model in terms of a one-shot game
i.e. only one amount of output actually put onto market vis. Cournot equilibrium level of output qn
But, it is assumed that each firm goes through a rational sequential decision making process before implementing its output choice

45. III. Oligopoly
The Cournot equilibrium may be re-interpreted in this sense as a Nash Equilibrium
That is, an equilibrium in which each party is maximising his utility given the behaviour of all the other parties
I am doing the best I can do, given what you are doing; and vice versa

46. III. Oligopoly Stackelberg competition
Variation of Cournot in which firm a announces its output and, once that announcement is made, the output cannot be changed.
i.e. one-shot game or repeated game in which firm a produces the same level of output in each period.

47. III. Oligopoly Assume: Firm 1 - market ‘leader’
Firm 2 - market ‘follower’
N.B. firm 1 has to be able to make a credible, binding commitment to a particular output level

48. Figure 7: Stackelberg Competition20 E1 E2 Es 5
D´ = AR´ q
100 MR
MR´

49. III. Oligopoly Bertrand Competition
Both Cournot and Stackelberg assume that firms chose outputs with prices determined by the inverse demand functions.
But in many oligopolistic markets firms appear to set prices and then sell whatever the market demands at those prices

50. III. Oligopoly
In perfect competition and monopoly, it makes no difference whether we carry out analysis in terms of prices or quantities
That is, price determines quantity and quantity determines price
But in oligopoly the distinction is crucial

51. III. Oligopoly
Bertrand presented an alternative to the Cournot model in his review of Cournot’s book.
He asked the question, what would be the outcome if the two firms chose prices:
(a) simultaneously
(b) independently
And then sold all the output that was demanded at these prices via the inverse demand functions

52. III. Oligopoly Conclusion Completely different result emerges
Equilibrium which replicates perfectly competitive (i.e. allocatively efficient) equilibrium in which p = MC

53. III. Oligopoly
Firms compete with each other by marginally undercutting the other’s price (assuming homogenous good, costs etc.) and thus taking the whole market
Process continues until the only equilibrium is one where each firm sets price equal to marginal cost

54. III. Oligopoly Nash equilibrium in Bertrand is p1 = MC = p2
Rationalisation for the equilibrium is on the same lines as in Cournot model vis. no other pair of prices has the property of mutual consistency.
Bertrand intended this to be a reductio ad absurdum and to demonstrate the weakness of Cournot’s approach

55. Figure 8: Bertrand Competition
Monopoly Equilibrium Em pm
Bertrand Equilibrium Eb MC pb
D = AR q qm qb MR

56. III. Oligopoly
Bertrand model yields a striking prediction from a quite reasonable model
If outputs are homogenous, an increase in the number of firms in the market from one to two leads from the monopoly equilibrium directly to the perfectly competitive equilibrium!

57. IV. Game Theory
Game; situation in which intelligent decisions are necessarily interdependent
The players in the game attempt to maximise their own payoffs via a strategy
Strategy; game plan describing how the player will act (or move) in every conceivable situation.
Equilibrium Concept - Nash

58. IV. Game Theory
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma

59. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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60. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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61. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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62. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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63. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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64. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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65. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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66. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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67. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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68. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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69. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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70. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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71. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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72. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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73. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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74. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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75. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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76. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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77. IV. Game Theory Prisoner’s Dilemma Player 2 Confess Deny Player 1
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78. IV. Game Theory
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma

79. IV. Game Theory Nash Equilibrium ; Confess, Confess
Indeed, to confess is each player’s ‘dominant strategy vis. optimal strategy that is independent of the strategy of the other player(s)
Recall, ‘collusion versus competition’

80. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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81. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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82. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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83. IV. Game Theory Collusion versus Competition Firm 2 Renege Collude
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84. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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85. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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86. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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87. IV. Game Theory Collusion versus Competition Firm 2 Collude Renege
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88. IV. Game Theory Collusion versus Competition Firm 2 Renege Firm 1
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89. III. Oligopoly First-best (i.e. dominant strategy) would be to renege
Second-best would be a voluntary arrangement to maintain the cartel output (but, restrictive practices are usually illegal and so agreements are usually tacit)
And again, temptation to reach the first-best renders the second-best unsustainable and so forces players to the third-best

90. III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma

91. III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma

92. III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma

93. III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma