Imperfect Competition
Chapter 9
LIPSEY & CHRYSTAL
ECONOMICS 12e
Learning Outcomes
• Concentration of production varies between industries, but
firms in all intermediate industry types have some power
to influence price.
• In industries where there are many producers but of
different products, free entry will tend to eliminate profits in
the long run.
Learning Outcomes
• Where there is a small group of dominant producers
(oligopoly), strategic interaction is important because the
market form of one is affected by what its rivals do.
• Insights into the choices available and the nature of
outcomes can be achieved using game theory.
• Oligopoly can be associated with pure profits in the long
run if there are barriers to entry.
INTRODUCTION - IMPERFECT COMPETITION
Imperfectly Competitive Market Structures
• Firms in market structures other than perfect competition
face negatively sloped demand curves and must
administer their prices.
INTRODUCTION - IMPERFECT COMPETITION
Monopolistic Competition
• In the theory of large-group monopolistic competition,
many firms compete to sell differentiated products.
• Each may make pure profits in the short run. In the long
run, freedom of entry shifts its demand curve until it is
tangent to the ATC curve, leading to excess capacity
and production at average costs above the minimum
possible level.
INTRODUCTION - IMPERFECT COMPETITION
Oligopoly
• Competitive behaviour among oligopolists may lead to
a non-cooperative equilibrium.
• It is self-policing in the sense that no one has an
incentive to depart from it unilaterally.
• The prisoner’s dilemma game is a case in point.
INTRODUCTION - IMPERFECT COMPETITION
Oligopoly
• Oligopolistic profits can persist only if there are entry
barriers.
• Natural barriers include economies of large-scale
production and large fixed costs of entering the market.
• Artificial barriers include brand proliferation and high
levels of advertising.
INTRODUCTION - IMPERFECT COMPETITION
Oligopoly as a Game
• Small-group interaction can be analysed using a game
theory framework, which sets out the available actions
and the payoffs under various actions.
• In a Nash equilibrium each firm is doing the best it can,
given the choices that other firms have made.
• A co-operative solution is likely to be the one that
maximizes joint profits, but each firm will typically have
an incentive to cheat, and explicit co-operation
between firms may be proscribed by competition law.
INTRODUCTION - IMPERFECT COMPETITION
Dynamics of Oligopoly Industries
• In qualitative terms the workings of the allocative
system under oligopoly are similar [but not
identical] to what they are under perfect
competition.
• Oligopolistic industries appear to have contributed
much more to the technological changes that
underlie the long-run growth of productivity than
have perfectly competitive industries.
[i] Equilibrium of a Typical Firm in Monopolistic Competition
MC
Es
ATC
ps
D
MR
Output
qs
[I]. Short-run equilibrium
(i) Short run equilibrium for a firm in monopolistic competition
 A typical monopolistically competitive firm is shown in short-run
equilibrium is at point ES.
 Output is qs, where MC = MR, price is ps.
 Profits are the blue area.
[ii] Equilibrium of a Typical Firm in Monopolistic Competition
MC
ATC
EL
pL
pc
D
MR
qL
Output
qc
[ii]. Long-run equilibrium
(ii) Long run equilibrium of a firm in monopolistic competition
 Here the firm is in long-run equilibrium at point EL.
 Entry of new firms has pushed the existing firm’s demand curve to
the left until the curve is tangent to the firm’s ATC curve at output
qL .
 Price is pL, and total costs are just being covered. Excess
capacity is qC-qL.
 If the firm did produce at capacity, its costs would fall from pL per
unit of output to pC.
The Oligopolist’s Dilemma: to Co-operate or to Compete
One-half
monopoly
output
20
20
15
Two-thirds
monopoly
output
B’s output
A’s output
One-half
Two-thirds
monopoly
monopoly
output
output
22
15
17
22
17
The Oligopolist’s Dilemma: to Co-operate or to Compete
 The figure gives a payoff matrix for a two-firm duopoly game.
 A’s production is indicated across the top. Its profits (in millions of
pounds) are shown in the yellow circles within each square.
 B’s production is indicated down the left side.
 Its profits (in millions of pounds) are shown in the green circles within
each square.
 For example, the top right square tells us that if B produces one-half,
while A produces two-thirds, of the output that a monopolist would
produce:
 A’s profits will be £22 million
 while B’s will be £15 million
The Oligopolist’s Dilemma: to Cooperate or to Compete
 If A and B co-operate, each produces one-half the monopoly
output, and earns profits of £20 million as shown in the upper left
box.
 In this co-operative solution, either firm can raise its profits by
producing two-thirds of the monopoly output, provided that the
other firm does not do the same.
 Now let A and B behave non-cooperatively.
 A reasons that whether B produces either one-half or two-thirds
of the monopoly output, A’s best output is two-thirds.
 B reasons similarly.
 As a result, they reach the non-cooperative equilibrium.
 Here each produces two-thirds of the monopoly output, and each
makes less than it would if the two firms co-operated.
The Prisoner’s Dilemma
John’s plea
Innocent
Innocent
William’s
plea
Guilty
J light sentence
W light sentence
J severe sentence
W no sentence
Guilty
J no sentence
W severe sentence
J medium sentence
W medium sentence
The Prisoner’s Dilemma
 Two prisoners are interrogated separately.
 They are told:
 if they both plead innocent, they will get a light
sentence.
 If one pleads innocent while the other pleads guilty, the
one who claims innocence will get a heavy sentence
while the other will be let off.
 If both plead guilty, they will both get a medium
sentence.
 The pay off matrix shows these conditions.
The Prisoner’s Dilemma
 Both prisoners reason as follows
 (1) if the other pleads innocent I am better off to plead
guilty and get off.
 (2) if the other pleads guilty I am better off to plead
guilty and get only a medium sentence.
 So the optimal non-cooperative strategy for both is to plead guilty
 This gives them a medium sentence rather than the light sentence that
they would get if they were allowed to consult and agree that both
would plead innocent.