Frank & Bernanke
Chapters 9 & 10
Imperfect competition
1
Outline
2
Monopoly
Monopoly power
Barriers to entry
“Natural monopoly”
Profit maximization by a monopolist
Efficiency of imperfect competition


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
Other forms of imperfect competition
Oligopoly and monopolistic competition
Game theory
Oligopoly models





The kinked demand curve model
Cartels and collusion
Price Taker v. Price Setter
3
 Perfectly Competitive Firm
 A firm that must take the price in the market
 A price taker
 Imperfectly Competitive Firm
 A firm with at least some latitude to set its own price
 A price setter
Forms of Imperfect Competition
4
 Pure monopoly
 A firm that’s the only supplier of a unique product with
no close substitutes
 Oligopoly
 A market with a handful of firms (2-12) producing a
product for which only rival firms produce close
substitutes
 Monopolistic competition
 A market with a large number of firms that produce
slightly differentiated products that are reasonably close
substitutes for one another.
Competition v. imperfect competition
5
 A perfectly competitive firm faces a perfectly
elastic demand curve for its product
Firms take the price in the market, where supply and
demand curves intersect
 Charging a higher price or a lower price does not help
increase profits

 An imperfectly competitive firm faces a downward-
sloping demand curve

Charging a price different from competitors may be
advantageous
Pure Monopoly
6
 Very rare on a global scale (DeBeers?)
 Not as rare:
 Local/regional monopoly
 Firms with a lot of market power
Market Power
7
 Monopoly Power (Market Power)
 A firm’s ability to raise the price of a good without losing all its
sales
 It does not mean that a firm can sell any quantity at any price
it wishes (if firms raise price, quantity demanded falls).

i.e. they must remember the law of demand
Sources of Market Power
8
 Market power arises from factors that limit
competition = “barriers to entry”

Something prevents other firms from entering the market
Barriers to Entry
9
 Economic barriers
 Exclusive control over inputs (DeBeers, ALCOA)
 Economies of scale (lower average costs)

“Natural monopoly”
 Legal barriers
 Patents
Grant exclusive rights for a specified time period
 Promote monopoly but encourage innovation


Government licenses or franchises
 Technological barriers
 Tech superiority
 Tech may give rise to natural monopoly
Economies of Scale & Natural Monopoly
10
 With “Economies of scale” (a.k.a. “increasing returns
to scale”)…





Average cost of production falls as output increases
High start-up (fixed) costs followed by low marginal costs
Suggests larger firms will be more efficient than smaller firms
When we see firms merge, we can assume that they are
achieving economies of scale (lower average costs and higher
per unit profit) by doing so
When is IRTS likely to happen?

What are some examples of goods or services where firms have
merged?
Total and Average Costs for a Production Process with
Economies of Scale
11
“Natural Monopoly”
12
 In some markets, it makes more sense (is more
efficient) to only have a single provider of the good.
 Economies of scale are so great that the good or
service can be provided at the lowest cost if only
one firm provides it.
 E.g. Utilities
How many sets of phone lines, water pipes, cable wires,
electric lines … do we need?
 Since monopoly power is dangerous (to consumers) what
must we do with natural monopolies?

Returns to Scale
13
 Increasing returns to scale
 When all inputs are changed by a given proportion and output
changes by a higher proportion
 Also know as Economies of Scale
 Constant returns to scale
 When all inputs are changed by a given proportion and output
changes by the same proportion
 Decreasing returns to scale
 When all inputs are changed by a given proportion and output
changes by a lower proportion
 Firm is “too big”
Returns to scale
14
 Reasons for IRTS
 Increased ability for division of labor (specialization)
 More output may justify the use of high-tech capital
 Inputs can be purchased in bulk
 By-product can be reused/resold
 Reasons for DRTS
 Thick corporate hierarchy slows decision-making
 Less oversight may result in more shirking/disconnect from
labor
Profit maximization by a monopolist
15
 Monopolist’s general strategy:
 Restrict output
 Stimulate demand
 Monopolist must determine both Q* & P*
Monopolist’s Marginal Revenue
16
 Marginal Revenue
 The change in a firm’s total revenue that results from a oneunit change in output
 For a monopolist
 marginal revenue from selling an additional unit is less than
the market price

Note that a monopolist can only sell an additional unit if it cuts
prices on all units it sells (i.e. the seller does not engage in price
discrimination)
Aside: Price Discrimination
17
 Price Discrimination
 The practice of charging different buyers different prices for
essentially the same good or service
Discounts to senior citizens, children
 Discounts on air travel depending on days of travel
 Rebates or coupons on retail merchandise
 Novel sales

 Effective when the good or service cannot be resold
Types of Price Discrimination
18
 Perfect price discrimination
 A firm that charges each buyer exactly his or her reservation
price (rare)
 Hurdle method of price discrimination
 The practice by which a seller offers a discount to all buyers
who overcome some obstacle
A rebate that takes time and effort to mail in
 Time spent waiting
 Staying over a weekend on air travel

Benefits of Price Discrimination
19
 The number of trades increase
 Brings output closer to the socially efficient level
 Reduces efficiency loss associated with market power and
increases total economic surplus
The Demand Curves Facing Perfectly and Imperfectly
Competitive Firms
20
The Monopolist’s Benefit from Selling an Additional Unit
21
Marginal Revenue in Graphical Form
22
Profit Maximization
23
 Goal of all firms: Maximize profits
 Rule
 Expand output when MR > MC
 Decrease output when MC > MR
 Sell the quantity of output where marginal revenue equals
marginal cost, MR = MC
The Profit-Maximizing Output Level for a Perfectly
Competitive Melon Farmer
24
Profit-Maximizing Rule
25
 Firm with market power must set quantity and price
 Profit is maximized at the level of output for which
MR = MC
 A monopolist sets the price off of the demand curve
at its profit-maximizing output
The Monopolist’s Profit-Maximizing Output Level
26
Monopoly and Efficiency
27
 Recall, the market efficient level of output is where
MB = MC

The monopolist produces less than socially efficient level of
output
Monopolists are not efficient
 Inefficiency is measured by deadweight loss

 Monopoly may be socially inefficient, but the
alternatives, like legislation, are not perfect either
The Deadweight Loss from Monopoly
28
Chapter 10:
Thinking Strategically
29
Oligopoly
30
 A handful of big firms selling a product with some quality
differentiation

Rule of thumb: if 4 biggest players together have 40% or more of
total market share
Chips
 Soda
 Beer
 Airlines
 Insurance
 Cell phone providers
 Automobiles
 Cigarettes
 Athletic shoes
 Online travel booking sites

Profit in oligopoly?
31
 Do these firms make economic profit > 0?
 Do these profits persist into the long-run?
 What must be true?
The kinked demand curve model of Oligopoly
32
 Observation: prices in oligopoly markets tend to
change very slowly.

Why?
 Assume no cooperation or collusion among firms
 Considering the relationship between price
changes, elasticity of demand and revenue changes
helps explain this observation.

Individual firms are basically afraid to change price because
of what other firms might do.
Kinked Demand Curve
33
 Assume that we have 3 firms: A, B, & C
 Products are similar
 The shape of the demand curve for A’s product
tells us how much QD changes when there is a
price change (elasticity) – this depends on the
pricing behavior and similarity of the substitutes B
and C.
Kinked Demand Curve
34
Consider what might happen if firm A changes price:
1. If firm A lowers price then B and C can follow the price change or ignore it.

If B and C follow then they also lower price because they are afraid of losing their market
share to firm A.

If B and C ignore the price change by A, then they maintain the higher price because they
don’t believe that people will switch.
2. If firm A raises price then B and C can follow the price change or ignore it.

If B and C follow then they also raise price because they don’t believe that people will
switch, so they can increase profits by also charging more.

If B and C ignore the price change by A, then they maintain the lower price because they
believe that people will switch, and they can capture some of firm A’s market share by
having a lower price.
Kinked Demand Curve
35
If competitors B and C consider their product to be a reasonable substitute
for A’s product, they are likely to ignore (not follow) a price increase and
follow a price decrease:
If A raises price and B and C do not follow:
 consumers are more likely to substitute toward B and C
 increase in the Price of A => big decrease in QD for A
 If the other firms do not follow the price increase then the demand for
A’s product will be relatively ELASTIC (flat slope) at prices above the
current price.
If A lowers price and B and C do follow:
 consumers are less likely to substitute toward B and C
 decrease in the Price of A => small increase in QD for A
 If the other firms do follow the price decrease, then the demand for A’s
product is going to be relatively INELASTIC (steep slope) at prices below
the current price.
Kinked Demand Curve
36
 When firms believe that their product is a close
substitute for their competitor’s product, they do
not have much incentive to change price:


A price decrease will be matched, so they have nothing to
gain by lowering price.
A price increase will not be matched, so they have a lot to
lose by raising price.
Theory of Games
37
 The payoff of many actions depends
upon the actions of others
 For
example, an imperfectly competitive
firm must weigh the responses of rivals
when deciding whether to cut their prices
 The decisions of competing firms are often
interdependent
Game theory
38
 A mathematical technique for analyzing the
decisions of interdependent oligopolistic firms in
uncertain situations.

History:
(1838) 1st observations on oligopoly behavior
 Darwin (1878) competition and evolutionary bio
 Von Nuemann (1928) minimax strategy
 Dresher and Flood (1950) The prisoners dilemma
 Nash (1950-1953, 1994) Bargaining theory and Nash equilibria
 Cournot
Game Theory
39
 A “game” is simply a competitive situation
where two or more firms or individuals
pursue their interests and no person can
dictate the final outcome or “payoff”.
 Players choose their strategy without certain
knowledge of the other players strategies,
but may eventually learn which way the
opposition is leaning.
Elements of a Game
40
 Basic elements
 The players
 The strategies
 The payoffs
 Payoff matrix
 The fundamental tool of game theory.
 This is simply a way of organizing the potential outcomes
of a given game in a table that describes the payoffs in a
game for each possible combination of strategies
Strategies
41
 Dominant strategy
 A strategy that yields a higher payoff no matter what the other
players in a game choose
 Dominated strategy
 Any other strategy available to a player who has a dominant strategy
 Nash Equilibrium
 Any combination of strategies in which each player’s strategy is his
best choice, given the other players’ strategies.
 IOW: Nash equilibrium is achieved when all players are playing
their best strategy given what the other players are doing.
 Nash equilibrium does not necessarily mean the best payoff for all
the players… a better payoff may be achieved through collusion.
A simple game and payoff matrix
42
 Duopoly situation – each of the two firms A and B must
decide whether to mount an expensive advertising
campaign.
 If each firm decides not to advertise, each will earn a profit
of $50,000.
 If one firm advertises and the other does not, the firm that
does will increase its profits by 50% to $75,000, and drive
the competition into a loss.
 If both firms advertise, they will earn $10,000 each
because the advertising expense forced by competition
wipes out large profits
Example continued…
43
 If firms could agree to collude, the optimal strategy
would obviously be to not advertise – maximize
joint profits = $100,000

Let’s assume they cannot collude, and therefore do not
know what the competition is doing.
 A “Dominant Strategy” is the one that is best no
matter what the opposition does.
The Payoff Matrix
44
Firm B
Don’t Advertise
Don’t
Advertise
Advertise
A profit = $50
A loss = $25
B profit = $50
B profit = $75
A profit = $75
A profit = $10
B loss = $25
B profit = $10
Firm A
Advertise
New Game: “The Prisoner’s Dilemma”
45
 You and your friend Bugsy are the prime suspects for knocking over a liquor store.
The cops pick you up, and immediately after your arrest you and Bugsy are
separated and questioned individually by the DA. Without a confession, the DA
has insufficient evidence for a conviction. During your interrogation, you are told
the following:
 The police do have sufficient evidence to convict you and Bugsy of a lesser crime.
 If you and Bugsy both confess to the liquor store heist, you will each get a 5 year




sentence.
If neither of you confesses, you will each be charged with the lesser crime, and sent
up the river for 1 year.
If Bugsy confesses (turns state’s evidence) and you do not, Bugsy will go free while
you will be convicted of the liquor store robbery and get sent to the big house for 7
years.
Bugsy is told the exact same information.
What will you do?
The Payoff Matrix
46
You
Don’t Confess
Don’t
Confess
Bugsy
Confess
Confess
Bugsy = 1 year
Bugsy =7 years
You = 1 year
You = Free
Bugsy = Free
Bugsy =5 years
You = 7 years
You = 5 years
Prisoner’s Dilemma
47
 Prisoner’s Dilemma
 Each player has a dominant strategy
 It results in payoffs that are smaller than if each had played a
dominated strategy
 Produces conflict between narrow self-interest of
individuals and the broader interest of larger
communities
Naturalist applications of prisoner’s dilemma
48
 Why do people shout at parties?
 Why does everyone stand up at concerts?
There are some games where one player does not have a dominant
strategy but the outcome is predictable …
49
A
Left
Top
B
Bottom
Right
B: +100
B: +100
A: 0
A: +100
B : -100
B: +200
A:0
A: +100
A’s behavior is predictable in this case.
One more …
50
Left
A
Right
B: +100
B: + 100
A: 0
A: +100
B: -10,000
B: + 200
A: 0
A: + 100
Top
B
Bottom
Here, A’s behavior is again predictable – choose Right is the
dominant strategy – but now B stands to lose a great deal if by
chance A chooses left instead
Cartels
51
 Cartel
 A group of firms who sell a similar product who have
joined together in an agreement to act as a monopoly –
restrict output and raise price
 Normally cartels involve several firms


Make retaliation against a dissenter difficult
Agreements are not legally enforceable and are hence
inherently unstable
Reasons for collusion among firms
52

To reduce the uncertainty of a noncooperative
situation – competition over market share makes
firms unsure of what to do with regard to pricing
decisions – they’re afraid to change prices – so
to avoid the possibility of a price war, firms
might try to cooperate.

To increase profits – this need for profit can turn
out to be the downfall of most cartels – GREED
Collusion
53

Overt collusion is illegal in the US.

Most cartels fail. This is because 3 things are needed for a cartel to be successful, and
they’re tough to accomplish –

1st, the firms must come to an agreement as to what the price and quantity should be –
tough to do because different firms will have different cost structures and different
assessments of market demand, so what is the profit-maximizing price and quantity for
one firm is not likely to be the profit-maximizing combination for another firm.

2nd, the cartel members must adhere to the agreed upon price and production levels –
no cheating. But each firm knows that if it cheats and the others do not, that they can
have higher profits.

3rd, there must be the potential for monopoly power – the market demand curve must
be relatively inelastic so that there are potential gains from increasing price – it has to be
a good with few substitutes.
Is the NCAA a cartel?
54
 Where do the big profits come from at large state schools?
 sports
 Is it a competitive market?
 many schools… but the large profits suggest that there is some
monopoly power.
 The NCAA creates this market power and profit by
restricting output – limit the number of games per season,
limit the number of teams per division, strict eligibility
guidelines for schools…
 Up until 1984 the NCAA restricted the number of games on
TV and charged very high prices compared to today – but
the supreme court called it illegal collusion and as a result
we have much more games on TV today than 20 years ago.
 Can we say the same things can be said for professional
sports?
Example: collusion
55
 2 firms sell bottled water with MC = 0
 The firms agree to act as a monopolist and set price
in order to maximize joint profits (P*).
 Each will produce ½ of the output.
 No enforcement mechanism.
 Cheating by 1 firm = selling the water at < P* =>
that firm gains entire market.
The Market Demand for Mineral Water
Q* = 1000, P* = 1.00 = > profits = $500 each
56
Temptation to Violate the Cartel Agreement
if 1 firm cheats => profits = $990 & 0
57
Practice
58
Create the payoff matrix for this game:
 Firms 1 & 2
 Options: collude (price = $1.00) or cheat (price =
0.90)
 Is there a dominant strategy for each firm?
 Is there an incentive to cut prices even more?
Exam 2
59
 Thursday August 4, 6:00-9:00
 Same format as exam 1:
 25 short answer
 2 essays (with options)