Lecture 3:
Imperfectly Competitive Markets
Required Text: Chapter 2
Market Models
Monopoly
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When there many buyer of a good with no close substitutes
but only one seller, the market is called a monopoly.
 Bt cotton (of Monsanto)
 Windows (of Microsoft Corporation)
The extent of monopoly hinges crucially on whether there
are close substitutes available
 KFC sells a unique type of chicken with 11 herbs and
spices
 Still KFC is not a monopoly, because there are many
other restaurants selling similar fried chicken
 Due to competitors, KFC cannot set any price it wants
Monopoly
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A monopolist faces a downward sloping demand curve (i.e., the
market demand)
Since a monopolist is the only seller of the good, it can set
whatever price it wants – price setter
The monopolist faces a trade-off though – the higher the price it
charges, the less consumers will buy
The monopolist sets the price that maximizes its profits
Profit maximizing condition: MR = MC
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A monopolist sells the quantity where MR and MC curves intersect
The monopolist sets a price corresponding to that optimal
production point on the market demand curve
Monopoly Price and Output
Monopoly
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A monopolist faces a downward sloping marginal revenue
curve, which always lies underneath the demand curve.
 Because, the monopolist has to lower the price to sell
an additional unit of the good – lowers price to increase
output
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A Monopolist operates on the elastic portion of the
demand curve
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A monopolist do not have a supply curve, because there is
no “going price.”
Sources of Monopoly Power
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Natural monopoly
 Industry where AC curve decreasing at the point
where crosses market demand
 Industry survives only if monopolized
Patents
 Ex. photography
Resource monopolies
 Single firm controls productive input
Legal barriers to entry
Natural Monopoly
Price Discrimination
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Charging different prices for identical items
Ability to prevent resell of low-price units
First-degree Price Discrimination
 Charging different customers different prices (as the
customers are most willing to pay) for an identical good
Second-degree Price Discrimination
 Charging same customer different prices for different
unit of the same good
Third-degree Price Discrimination
 Charging different prices for the same good in different
markets
Third-degree Price Discrimination
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Charging different prices in different markets
 Groups of consumers identifiable
 Different downward sloping demand curve
 Producer profit
 Production of goods where MR same in both markets
and equal to MC
 More elastic demand group receives lower price
Third-Degree Price Discrimination by a Monopolist
in Two Markets
Two-Part Tariffs
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Entry fee allows purchase of goods or services
 Meaning of tariff
Customers are charged maximum willingness to pay
 Measure consumer’s surplus
 Charge competitive price as long as no difference in
consumers
 Charge low initial fee and high usage fee
Pricing Strategy with a Two-Part Tariff
Monopsony
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When there many seller of a good with no close substitutes
but only one buyer, the market is called a monopsony.
 College athletes – NCAA
 Even though college athletes have their choice of schools
to attend, the NCAA limits the compensation they can
receive.
 In a sense al college athletes work for the NCAA, and the
NCAA has complete control over the prices paid to the
athletes.
A monopsonist is a consumer – it is the only consumer.
 It seeks to maximize its consumer surplus
Monopsony
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A monopolist faces a upward sloping supply curve (i.e., the
market supply)
Since a monopsonist is the only buyer of the good, it can set
whatever price it wants – price setter
The monopsonist faces a trade-off though – the lower the price it
pays, the less sellers will sell
The monopsonist sets the price that maximizes its profits
Profit maximizing condition: MV = ME
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A monopsonist purchases the quantity where marginal expenditure
(ME) and marginal value (MV) curves intersect
The monopsonist pays a price corresponding to that optimal
consumption point on the market supply curve
Monopsony
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A monopsonist’s marginal value or demand curve is
downward sloping.
A monopsonist’s marginal expenditure curve is upward
sloping, which always lies above the marginal cost (supply)
curve.
 Because, the monopsonist has to raise the price to purchase
an additional unit of the good – increases price to increase
consumption
A Monopolist operates on the elastic portion of the demand
curve
Monopsony Equilibrium
ME
MC = Supply Curve
P
MV = Demand Curve
Q
Monopolistic Competition
(Differentiated Competition)
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When a market consists of many firms, each competing to sell a
different variety of a product or service, each variety being
different in some way but a close substitute for one another, the
market is called a monopolistic competition.
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Hamburgers sold by McDonalds, Burger King, Wendy’s, etc.
Soda, candy, fast food, etc.
Each firm produces a differentiated good, which is not imitated
perfectly by any other firm. However, other firms produces
varieties that are close substitutes.
Since each firm sells a unique variety of a product, each firm is
like a “small monopoly.”
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Each firm can set any price for that variety – monopoly market power.
Monopolistic Competition
(Differentiated Competition)
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Like a monopoly, a monopolistic firm faces a downward sloping
marginal revenue (MR) curve, that lies below the demand curve
it faces, and maximizes its profits by producing where MR=MC.
MC = Supply Curve (firm)
P
MV = Demand Curve (firm)
MR (firm)
Q
Monopolistic Competition
(Differentiated Competition)
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Since each firm produces a differentiated good, there is a single
marginal value (demand) curve for each variety, and single
marginal cost (supply) curve for each variety.
In a monopolistic competition, there is so much competition
among the many sellers of a differentiated product that the price
results often appear similar to those of a perfect competition.
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Unlike a real monopoly there is free entry and exit of other firms that
produce close substitutes.
Each time a new firm enters with its own variety, the demand curve for
all other firms falls.
The greater the variety, the less each consumer is willing to pay for any
single variety.
Monopolistic Competition
(Differentiated Competition)
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Each time a new firm enters with its own variety, the demand
curve for all other firms falls – that is the market share of
other firms falls.
MC = Supply Curve (firm)
P
MV = Demand Curve (firm)
MR (firm)
Q
Monopolistic Competition
(Differentiated Competition)
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Whenever producer surplus per firm is greater than fixed costs,
new firms will enter the market with new varieties, decreasing
the demand curve facing all firms.
Similarly, when producer surplus per firm is less than fixed
costs, some firms will begin to leave the market.
As firms enter and exit the market, they will eventually settle on
an equilibrium where economic profits are zero.
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At zero economic profits, each firm is making just as much money
it could in their next best alternative.
Producer surplus per firm equals the fixed cost for the firm – firms
are indifferent between producing or not.
Oligopoly
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When there only a few sellers of a product or service and many
buyers, the market is called an oligopoly.
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There are only a few sellers of credit cards – Visa, MasterCard,
Discover, and American Express.
Anheiser-Busch, Miller, and coors collectively sell 90% of all beers
purchased in the US
The soda market is dominated by Coca-Cola and Pepsi
Five beef packing firms sell 80% of all beef processed in the US.
Oligopolies can exist for a number of reasons
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Economies of scale – to produce a good at low per unit cost, you need
to “get big.”
Limited demand for any one product – once the market is saturated by
a few big firms, entering the market would not be profitable.
Oligopoly
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The price that results from an oligopoly follows no simple
formula – the reason is that oligopoly firms engage in strategic
behavior.
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When Pepsi increases its advertising, so does Coca-Cola.
Firms in an oligopoly have incentives to both collude and
compete.
Tacit Collusion: Sometimes, without explicit planning
oligopoly firms charge similar high prices, which are close to
the monopoly price.
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Unsolicited understanding that both will keep their prices high.
Neither reduces it’s price, because it is scared that the other firms will
retaliate with a price reduction in turn – price war.
Oligopoly
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Tacit collusion usually occurs through price leadership – where
one firm announces a price and all other firms respond with
similar price.
Price Warfare: Sometimes, oligopoly firms engage in price war
that leads to low prices close to that of perfect competition.
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Airline tickets – there are only a few airlines, but every airline struggles
to avoid bankruptcy.
Soups in grocery stores are not expensive – there are only a few vendors.
Because of collusion or competition, price can be low or high in
oligopolies.
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Oligopoly price lies somewhere in between the monopoly and perfect
competition prices.
Oligopsony
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When there only a few buyers of a good or service and many
sellers, the market is called an oligopsony.
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There are thousands of cattle producers (ranches and feedlots)
throughout the midwest, yet there are only few firms (beef packers) who
purchase cattle.
These cattle buyers have the power to depress prices, if they collude
with one another to keep price down – monopsony power.
However, the buyers also compete with one another for a limited supply
of cattle raising the purchase price – price warfare – competition.
Since both elements of collusion and competition are present in
oligopsony, price can be low or high.
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Oligoposony price lies somewhere in between the perfect competition
and monopsony prices.
Market Models Compared
Attributes
Perfect
Competition
Monopolistic
Competition
Oligopoly (seller)
Oligopsony
(buyer)
Monopoly
(seller)
Monopsony
(buyer)
Product
Homogenous
Differentiated
Homogenous or
differentiated
Differentiated
Number of Many
Firms
Many
Few
One
Entry
Easy
Fairly Easy
Difficult
Very difficult
to impossible
Market
Strategies
Timing and
volume of
sales
Set price,
brand names,
promotion,
product
design, and
packaging
Set price, if
differentiated then
establish brand
name, promotion,
product design,
and packaging
Set price
based on
MR=MC