Chapter 9Market structure and imperfect competition

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

7th Edition, McGraw-Hill, 2003

Power Point presentation by Alex Tackie

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Most markets fall between the two extremes of monopoly and perfect competition

• An imperfectly competitive firm– would like to sell more at the going price– faces a downward-sloping demand curve– recognizes its output price depends on the

quantity of goods produced and sold

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Imperfect competition

• An oligopoly– an industry with a few producers– each recognizing 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.

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Market structure

Numberof firms

Ability toaffectprice

Entrybarriers

Example

Perfect competition

Imperfect competition:

Monopolistic competition

Oligopoly

Monopoly

Many

Many

Few

One

Nil

Small

Medium

Large

None

None

Some

Huge

Fruit stall

Corner shop

Cars

Post Office

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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

DLAC1

LAC2

LAC3

Output

£

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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...

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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.

P1=AC1

£

OutputQ1

DMR

AC

MC

F

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Oligopoly

• A market with a 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

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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 permittede.g. OPEC

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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

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The kinked demand curve

Q0

P0

Quantity

£Consider how a firm may perceive its demand curve under oligopoly.

It can observe the currentprice and output,

but must try to anticipaterival reactions to anyprice change.

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Q0

P0

Quantity

£

The kinked demand curve (2)

The firm may expect rivalsto respond if it reducesits price, as this will be seenas an aggressive move

… so demand in response to a price reduction is likely to be relatively inelastic

The demand curve will be steep below P0.D

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The kinked demand curve (3)

…but for a price increaserivals are less likely to react,

so demand may be relatively elasticabove P0

so the firm perceivesthat it faces a kinkeddemand curve.D

Q0

P0

Quantity

£

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The kinked demand curve (4)

Given this perception, thefirm sees that revenue willfall whether price is increasedor decreased,

so the best strategy is to keepprice at P0.

Price will tend to be stable,even in the face of an increasein marginal cost.D

Q0

P0

Quantity

£

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Game theory: some key terms

• Game– 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

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The Prisoners’ Dilemma Game

Consider two firms in a duopoly each with a choiceof producing “high” or “low” output:

Firm B output

High Low

High 1 1 3 0

F

irm

A o

utp

ut

Low 0 3 2 2

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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

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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

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RA

The result is the reaction function in panel (b): the larger the output firm B is expected to sell the smaller is the optimal output of A.

Derivation of a firm’s reaction function

MC

QAQB

QA

£

MR0D0

QA0

p0

Assuming firm B produces zero output, A faces the market demand curve D0 and it maximizes profits by setting MR0 = MC and producing QA

0. p1

QA1

MR1

D1

When B produces some positive output, A faces the residual demand curve D1,sets MR1 = MC and produces QA

1.

p2

QA2

MR2D2

When firm B increases its output, A sets MR2 = MC and produces QA

2.

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Nash-Cournot equilibrium

RA

*Aq Aq

*Bq E

RB

QA*

QB*

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

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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.

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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

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Summary….

• The polar extremes of perfect competition and monopoly are rarely encountered in practice

• Imperfect competition is more the norm

• Economist’s used to say ‘market structure affects conduct which affects performance’

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• 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

Summary contd