Imperfect competition
©The McGraw-Hill Companies, 2002
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
– recognises its output price depends on the
quantity of goods produced and sold
1
©The McGraw-Hill Companies, 2002
Imperfect competition
• An oligopoly
– an industry with a few producers
– each recognising 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.
2
©The McGraw-Hill Companies, 2002
Market structure
Number Ability to Entry
Example
of firms affect
barriers
price
Perfect competition
Many
Nil
None
Fruit stall
Monopolistic competition
Many
Small
None
Corner shop
Oligopoly
Few
Medium
Some
Cars
Monopoly
One
Large
Huge
Post Office
Imperfect competition:
3
©The McGraw-Hill Companies, 2002
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.
£
LAC2
LAC3
LAC1
D
Output
4
©The McGraw-Hill Companies, 2002
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...
5
©The McGraw-Hill Companies, 2002
Monopolistic competition (2)
MC
£
•
Firms end up in TANGENCY
EQUILIBRIUM, making
normal profits.
AC
•
F
Firms do not operate at
minimum LAC.
P1=AC1
•
Price exceeds marginal cost.
•
Unlike perfect competition,
the firm here is eager to sell
MR
Q1
D
more at the going market
price.
Output
6
©The McGraw-Hill Companies, 2002
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 characterised by collusion
or by non-co-operation.
7
©The McGraw-Hill Companies, 2002
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 permitted.
• e.g. OPEC
8
©The McGraw-Hill Companies, 2002
Collusion is difficult if
• There are many firms in the industry
• The product is not standardised
• Demand and cost conditions are changing
rapidly
• There are no barriers to entry
• Firms have surplus capacity
9
©The McGraw-Hill Companies, 2002
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.
10
©The McGraw-Hill Companies, 2002
The kinked demand curve
Consider how a firm may
perceive its demand curve
under oligopoly.
£
P0
It can observe the current
price and output,
but must try to anticipate
rival reactions to any
price change.
Q0
Quantity
11
©The McGraw-Hill Companies, 2002
The kinked demand curve (2)
The firm may expect rivals
to respond if it reduces
its price, as this will be seen
as an aggressive move
£
P0
… so demand in response
to a price reduction is likely
to be relatively inelastic.
The demand curve will
be steep below P0.
D
Q0
Quantity
12
©The McGraw-Hill Companies, 2002
The kinked demand curve (3)
… but for a price increase
rivals are less likely to
react,
£
P0
so demand may be
relatively elastic
above P0
so the firm perceives
that it faces a kinked
demand curve.
D
Q0
Quantity
13
©The McGraw-Hill Companies, 2002
The kinked demand curve (4)
Given this perception, the
firm sees that revenue will
fall whether price is increased
or decreased,
£
P0
MC2 so the best strategy is to keep
MC1 price at P0.
D
Q0
Price will tend to be stable,
even in the face of an increase
in marginal cost.
Quantity
MR
14
©The McGraw-Hill Companies, 2002
Derivation of a firm’s reaction function
£
p0
p1
p2
MC
D
MR2 MR D2 MR0 1
1
QB
D0
QA
When firm B increases its output, A
sets MR2 = MC and produces QA2.
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.
RA
QA2 QA1 QA0
Assuming firm B produces zero
output, A faces the market demand
curve D0 and it maximises profits by
setting MR0 = MC and producing
QA0.
When B produces some positive
output, A faces the residual demand
curve D1,sets MR1 = MC and
produces QA1.
QA
15
©The McGraw-Hill Companies, 2002
Nash-Cournot equilibrium
QB
•
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
RA
q B*
QB*
E

RB
q *AA*
Q
QA
qA
16
©The McGraw-Hill Companies, 2002
Contestable markets
• A contestable market is characterised by free
entry and free exit
– no sunk costs
– allows hit-and-run entry
• Contestability may constrain incumbent firms
from exploiting their market power.
17
©The McGraw-Hill Companies, 2002
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
18
©The McGraw-Hill Companies, 2002
Summary….
• The polar extremes of perfect competition
and monopoly are rarely encountered in
practice.
• Imperfect competition is more the norm.
• Economists used to say ‘market structure
affects conduct which affects performance’.
19
©The McGraw-Hill Companies, 2002
Summary (cont.)
• 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.
20
©The McGraw-Hill Companies, 2002