Principles of Economics
Session 8
Topics To Be Covered
Imperfect Competition & Market Power
Characteristics of Oligopoly
Collusion vs. Competition
Kinked Demand Curve Model
Game Theory
Characteristics of Monopolistic Competition
Topics To Be Covered
Profits and Losses of the Monopolistic Firm
Long-Run Equilibrium of Monopolistic
Competitive Market
Monopolistic vs. Perfect Competition
Comparison and Contrast between
Four Types of Market Structure
Standards Wars
Four Types of Market Structure
Number of Firms
Many
firms
One
firm
Few
firms
Type of Products
Differentiated
products
Monopolistic
Competition
Identical
products
Perfect
Competition
Monopoly
Oligopoly
• Tap water
• Automobile
• Clothing
• Wheat
• Cable TV
• Crude oil
• Furniture
• Rice
Imperfect Competition
Imperfect competition refers to
those market structures that fall
between perfect competition and
pure monopoly.
Imperfect Competition
Imperfect competition includes
industries in which firms have
competitors but do not face so
much competition that they are
price takers.
Types of Imperfectly
Competitive Markets
Oligopoly
 Only
a few sellers, each offering a
similar or identical product to the
others.
Monopolistic Competition
 Many
firms selling products that are
similar but not identical.
Market Power
 Market power is the degree of control that a
firm or group of firms has over the price and
production decisions in an industry.
 The monopolistic firm has a high degree of
market power while perfectly competitive
firms have no market power.
 Measures of market power: concentration
ratio, Lerner’s index, Herfindahl-Hirschman
index
Concentration Ratio
 Concentration ratio is the percentage of an
industry’s total output accounted for by
the largest firms.
 A typical measure is the four-firm
concentration ratio, which is the fraction
of output accounted for by the four largest
firms.
Lerner’s Index
Lerner’s index is an efficient way to
measure the market power.
Costs, Revenue
and Price
L = (P - MC)/P
MC
P
E
P-MC
ATC
M
C
P
D= AR
MR
0
QMAX
Quantity
Herfindahl-Hirschman Index
 HHI is calculated by squaring the market
share of each firm competing in a market
and then summing the resulting numbers.
HHI ＝ S
2
i
i
 HHI ranges from a minimum of close to 0 to
a maximum of 10,000.
Herfindahl-Hirschman Index
 If HHI ＜ 1,000, the industry is considered as
competitive.
 If 1,000 ≤ HHI ＜1,800, the industry is
considered as moderately concentrated.
 If HHI ≥ 1,800, the industry is considered as
highly concentrated.
 As a general rule, mergers that increase the
HHI by more than 100 points in concentrated
markets raise antitrust concerns.
Herfindahl-Hirschman Index
 If there were only one firm in an industry,
that firm would have 100% market share
and the HHI would be equal to 10,000
(1002).
 If there were thousands of firms competing,
each would have a nearly 0% market share
and the HHI would be close to zero,
indicating nearly perfect competition.
Characteristics of an
Oligopoly Market
Small number of suppliers
 Similar or identical products
 Barrier to entry
 Interdependent firms

Small Number of Suppliers
As small as they might cooperate or
collude in such strategies as pricing.
Examples: automobiles, steel, computers
Barriers to Entry
Scale economies
Patents
Technology
Name recognition
Interdependence
In perfect competition, the producers do
not have to consider a rival’s response
when choosing output and price.
In oligopoly the producers must consider
the response of competitors when
choosing output and price.
Collusive Oligopoly
Oligigolopists can collude to form a cartel
in which they work together to raise
prices and restrict output.
Collusive oligopolists at large can profit
as a monopoly does.
Collusive Oligopoly
P
MC
Collusive
price
E
B
ATC
Average
total cost D
C
D
MR
0
Collusive Quantity
Q
Obstacles of
Effective Collusion
In the vast majority of countries, collusion
is illegal.
Members of the cartel are tempted to
cheat on the agreement.
With the development of international
trade, many oligopolists face intense
competition from foreign firms as well as
domestic companies.
The Kinked Demand Curve Model
The kinked demand curve model describes a
situation in which a firm assumes that other
firms will match its price reductions but will
not follow price increases.
The optimal strategy in such a situation is
frequently to leave the price at the current
level and to rely on nonprice competition
rather than price competition.
The model explains the price rigidity in the
oligopolistic industry.
The Kinked Demand Curve Model
P
If the producer raises price the
competitors will not and the
demand will be relatively elastic.
If the producer lowers price the
competitors will follow and the
demand will be relatively inelastic.
0
Q
The Kinked Demand Curve
P
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.
P*
MC”
MC’
MC
0
D
Q
Q*
MR
The Equilibrium for an
Oligopoly
A Nash equilibrium is a situation in
which economic actors interacting
with one another each choose their
best strategy given the strategies that
all the others have chosen.
How the Size of an Oligopoly
Affects the Market Outcome
 As
the number of sellers in an oligopoly
grows larger, an oligopolistic market looks
more and more like a competitive market.
 The price approaches marginal cost, and
the quantity produced approaches the
socially efficient level.
Game Theory:
Competition vs. Collusion
Game theory is the study of how people
behave in strategic situations.
Strategic situations are those in which
each person, in deciding what actions to
take, must consider how others might
respond to that action.
Game Theory:
Competition vs. Collusion
Because the number of firms in an oligopolistic
market is small, each firm must act strategically.
Each firm knows that its profit depends not only
on how much it produced but also on how much
the other firms produce.
An example in game theory, called the
Prisoners’ Dilemma, illustrates the problem
oligopolistic firms face.
The Prisoners’ Dilemma
Two prisoners have been accused of
collaborating in a crime.
They are in separate jail cells and
cannot communicate.
Each has been asked to confess to the
crime.
The Prisoners’ Dilemma
If they both confess, they both will be
sentenced to 5-year imprisonment.
If neither confesses, they both will be
sentenced to 2-year imprisonment.
If one confesses and the other does not, the
one who confesses will be sentenced to 1year imprisonment while the other will be
sentenced to 10-year imprisonment.
The Prisoners’ Dilemma
Peter’s Decision
Confess
A
Confess
Bob’s
Decision
Remain
Silent
-5
Remain Silent
B
-1
-5
C
-1
-10
-10
D
-2
-2
The Dominant Strategy
The dominant strategy is a situation
where one player has a best strategy
no matter what strategy the other
player follows.
The Dominant Equilibrium
When all players have a dominant
strategy, we say that the outcome is
a dominant equilibrium.
The Dominant Equilibrium
Peter’s Price
Normal Price
A
Normal Price
Bob’s
Price
Price War
$10
Price War
B
$10
C
-$10
-$10
-$100
-$100
D
-$50
-$50
The Dominant Equilibrium
Both Peter and Bob have a dominant
strategy, for the best decision for them
is to choose the normal price.
There is a dominant equilibrium for
them in cell A.
Collusion vs. Competition
P
P
MC
ATC
D
MR
Q
Q
The Nash Equilibrium
A Nash equilibrium is one in
which no player can improve his
or her payoff given the other
player’s strategy.
The Nash Equilibrium
Peter’s Price
High Price
A
Normal War
B
$150
$200
High Price
Bob’s
Price
Normal Price
$100
C
-$20
-$30
$150
D
$10
$10
The Nash Equilibrium
Bob has a dominant strategy, while Peter
does not. However, they can reach a Nash
equilibrium in cell D. Given Bob’s
strategy to charge a normal price, Peter
can can do no better than to charge a
normal price.
A dominant equilibrium is necessarily a
Nash equilibrium, but not vice versa.
The Invisible-Hand Game
Peter’s Strategy
Competitive Output
Competitive
Output
Bob’s
Strategy
Low Output
A
$0
$0
C
Low Output
B
$800
NI＝$5000
$600
-$50 NI＝$4500
-$100
D
NI＝$4400
$300
$250
NI＝$4000
Collusion vs. Competition
Self-interest makes it difficult for the
oligopoly to maintain a cooperative
outcome with low production, high prices,
and monopoly profits. However,
competition is more beneficial to society
and the invisible hand can make the
economy more efficient.
The Advertising Game
Peter’s Decision
Don’t Advertise
Advertise
Advertise
A
$30
B
$30
Bob’s
Decision
Don’t
Advertise
C
$50
$50
$20
$20
D
$40
$40
The Pollution Game
Peter Steel
High Pollution
Low Pollution
Low
Pollution
Bob Steel
High
Pollution
A
B
$120
$100
$100
C
-$30
-$30
$120
D
$100
$100
The Winner-Take-All Game
Work in Winner Work in WinnerStandard Industry
Take-All Industry
Work in
Standard
Industry
Runner-Up
Work in
WinnerTake-All
Industry
A
$50
$50
C
B
$50
NI＝$100
$50
$200 NI＝$250
$300
D
NI＝$350
$300
$0
NI＝$300
Why People Sometimes
Cooperate
Firms that care about future
profits will cooperate in repeated
games rather than cheating in a
single game to achieve a onetime gain.
Public Policy Toward
Oligopolies
Cooperation among oligopolists is
undesirable from the standpoint of
society as a whole because it leads to
production that is too low and prices
that are too high.
Monopolistic Competition
 Markets of monopolistic competition
are those that have features of both
competition and monopoly.
 It is the most common type of
market structure.
Characteristics of
Monopolistic Competition
 Many
sellers
 Differentiated products
 Free entry and exit
Many Sellers
There are many firms competing for
the same group of customers.
Examples: CDs, movies, restaurants,
furniture, etc.
Differentiated Products
Each firm produces a product that is
at least slightly different from those
of other firms.
Rather than being a price taker, the
firm can change its output and
consequently influence the price of
the product.
Free Entry or Exit
 Firms
can enter or exit the market
without restriction.
 It is the striking difference from the
monopolistic market which has
high barriers to entry and exit.
Demand Curves
Price
A Monopolistically
Competitive Firm
A Perfectly
Competitive Firm
Price
D=P=AR=MR
D=P=AR
0
Quantity of
Output
0
Quantity of
Output
Profit Maximization for
Monopolistic Competitors
Price
Price
Average
total cost
MC
ATC
D
Profits
MR
0
Profit-maximizing
quantity
Quantity
Loss Minimization for
Monopolistic Competitors
Price
MC
ATC
ATC
Price
Losses
D
MR
0
Loss-minimizing
quantity
Quantity
The Long-Run Equilibrium
Firms will enter and exit until
the firms are making exactly
zero economic profits.
A Monopolistic Competitor
in the Long Run
Price
MC
ATC
P=ATC
MR
0
Profit-maximizing
quantity
Demand
Quantity
Economic Profits and
Monopolistic Competition
Economic profits encourage new firms to
enter the market. The entry will:
Increase the number of products offered.
 Reduce demand faced by firms already in the
market.
 Shift the demand curve to the left.
 Decrease economic profit to zero in the long
run.

Economic Losses and
Monopolistic Competition
Economic losses encourage firms to
exit the market. The exit will:
Decrease the number of products offered.
 Increase demand faced by the remaining
firms.
 Shift the remaining firms’ demand curves to
the right.
 Increase the remaining firms’ accounting
profit until economic profit reaches zero in
the long run.

Two Characteristics of
Long-Run Equilibrium
As in a monopoly, price exceeds
marginal cost.
P ＞MC
As in a competitive market, price
equals average total cost.
P=ATC
Monopolistic versus Perfect
Competition
There are two noteworthy
differences between monopolistic
and perfect competition—
excess capacity and markup.
Monopolistic versus
Perfect Competition
Price
Monopolistically
Competitive Firm
MC
Markup
Price
ATC
P = MC
Perfectly
Competitive Firm
MC
ATC
P = MR
(demand
curve)
Marginal
cost
Demand
MR
Quantity
produced
Efficient
scale
Excess capacity
Quantity
Quantity produced =
Efficient scale
Quantity
Excess Capacity
 There
is no excess capacity in perfect
competition in the long run.
 Free entry results in competitive firms
producing at the point where average
total cost is minimized, which is the
efficient scale of the firm.
Excess Capacity
 There
is excess capacity in
monopolistic competition in the
long run.
 In monopolistic competition,
output is less than the efficient
scale of perfect competition.
Markup Over Marginal Cost
 For
a competitive firm, price equals
marginal cost.
 For a monopolistically competitive
firm, price exceeds marginal cost.
 Because price exceeds marginal
cost, an extra unit sold at the posted
price means more profit for the
monopolistically competitive firm.
The Number of Suppliers
and Efficiency
The larger the number of firms in the
market, the more elastic will be the
demand for each firm's product, and
the more efficient will be the market
Monopolistic Competition
and the Welfare of Society
 There
is the normal deadweight loss of
monopoly pricing in monopolistic
competition caused by the markup of
price over marginal cost.
 Monopolistic competition does not have
all the desirable properties of perfect
competition.
Monopolistic Competition
and the Welfare of Society
Price
Deadweight
Loss
MC
ATC
P=ATC
MR
0
Profit-maximizing
quantity
Demand
Quantity
Differentiation and
Market Power
The more differentiation of the product,
the greater the market power. Advertising
and innovation are means to realize the
product differentiation and get more
profit.
Advertising
 When
firms sell differentiated products
and charge prices above marginal cost,
each firm has an incentive to advertise in
order to attract more buyers to its
particular product.
 Overall, about 2 percent of total revenue is
spent on advertising throughout the world.
Advertising
 Critics
of advertising argue that firms
advertise in order to manipulate people’s
tastes.
 They also argue that it impedes
competition by implying that products
are more different than they truly are.
Advertising
 Defenders
argue that advertising provides
information to consumers.
 They also argue that advertising increases
competition by offering a greater variety
of products and prices.
 The willingness of a firm to spend
advertising dollars can be a signal to
consumers about the quality of the
product being offered.
Brand Names
 Critics
argue that brand names cause
consumers to perceive differences that do
not really exist.
 Economists have argued that brand
names may be a useful way for
consumers to ensure that the goods they
are buying are of high quality.
 providing
information about quality.
 giving firms incentive to maintain high quality.
Four Types of Market Structure
Perf.
Comp.
Collusive
Monopoly Oligopoly
Monop.
Comp.
No. of
Firms
Many
One
Few
Many
Collusion
None
None
Yes
None
P vs. MC
P = MC
P ＞ MC
P ＞ MC
P ＞ MC
P vs. LAC
P = LAC P ＞ LAC P ＞ LAC P = LAC
Efficiency
Efficient
Large
Loss
Large
Loss
Mod. to
Sm. Loss
Standards Wars
Two Basic Tactics
Preemption
 Build
installed base early
 But watch out for rapid technological
progress
Expectations management
 Manage
expectations
 But watch out for vaporware
Once You’ve Won
Stay on guard
 Minitel
Offer a migration path
Commoditize complementary products
 Intel
Competing against your own installed
base
 Intel
again
 Durable goods monopoly
Once You’ve Won, cont’d.
Attract important complementors
Leverage installed base
 Expand
network geographically
Stay a leader
 Develop
proprietary extensions
What if You Fall Behind?
Adapters and interconnection



Wordperfect
Borland v. Lotus
Translators, etc
Survival pricing


Hard to pull off
Different from penetration pricing
Legal approaches

Sun v. Microsoft
Microsoft v. Netscape
Rival evolutions
Low switching costs
Small network externalites
Strategies
 Preemption
 Penetration
pricing
 Expectations management
 Alliances
Assignment
Review Chapter 10 and 11
Answer questions on P186 and 205
Preview Chapter 12 and 15
Thanks
Economic Profit versus
Accounting Profit
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Explicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
The Long-Run Equilibrium of
Perfectly Competitive Market
Price
MC
ATC
P
0
P = AR = MR
Q
Quantity
The Long Run Equilibrium
of Monopolistic Market
Costs and
Revenue
MC
Monopoly E
price
B
ATC
Marginal
Cost D
C
D= AR
MR
0
QMAX
Quantity