Principles of Economics
Imperfect competition:
Monopoly, Oligopoly and
Monopolistic competition
Perfect competition on a product
market
Perfect competition
Imperfect competition
Demand
Horizontal (p = constant)
Downward sloping (p(q))
Product
Homogeneous
Heterogeneous
Information
Perfect
Imperfect
Profit
Zero profit
Extra profit
Number of sellers
Many
One or few
Price formation
Price takers
Price makers
Disadvantages:
•Smaller total surplus of the economy
•Smaller quantity on the market
Advantages:
•Technological progress (Schumpeter says innovations overpower
negative effect of smaller total surplus – SCHUMPETER HYPOTHESIS)
•Economies of scale
Market power
• Market power is analyzed using several
indicators:
1. Share of 4 biggest companies on the market
2. Herfindahl-Hirschmann index:
n
HHI  S  S  ...  S   Si2
2
1
2
2
0  HHI  10000
2
n
i 1
where S is a percentage share of each company on
the market.
In monopoly HHI = 10000, in perfect competition 0.
If HHI > 1800 concentration is high, if HHI < 1000
concentration is low and for 1000<HHI<1800
concentration is medium.
Dead weight loss
• Imperfect competition causes total surplus
decline – DEAD WEIGHT LOSS – it is a
difference between total surplus in perfect
competition (p = MC) and imperfect
equilibrium (MR = MC)
Monopoly
Properties:
• 1 seller, no substitutes.
• Monopolist can change price.
• There are barriers for entry (patents,
copyright, large starting investment)
• In perfect competition demand is horizontal (p
= MR), in monopoly demand is falling (MR < p)
• Monopolist maximizes profit: MC = MR < p
(in real life p = AC + margin
P
MC
M
AC
DWL
MR
0
P = AR
Q
•
•
•
•
Total revenue (TR) and marginal
revenue (MR)
TR = p×q
AR = p×q/q = p
MR = ΔTR/ Δq
When demand is falling TR
has bell-like form
• TR reaches its maximum
when │Ed│ = 1
• Note that MR and demand
are not the same curve as
in perfect competition
P
│Ed │ = 1
TR
MR
0 │Ed │ > 1
elastic
p = AR
│Ed │ < 1
inelastic
Q
Exercise 1
• Total cost function of a company is TC=40+2Q
and demand function is P=10-0,1Q. If TC=120,
what is the monopolist’s profit?
•
•
•
•
•
•
TC=40+2Q
120=40+2Q
Q=40
P=10-0,1Q=10-0,1*40=6
Π=TR-TC=P*Q-TC=240-(40+2*40)
Π=240-120=120
Exercise 2:
• Demand function is Q=200-10P. Marginal
revenue is MR=20-0.2Q, average costs are
AC=0,05Q+5+225/Q and marginal costs
MC=5+0,1Q. Find optimum price, production
and profit of this monopolist.
• MR=MC
• 20-0,2Q=5+0,1Q
• Q=50
• Q=200-10P
• P=15
• Π=TR-TC=P*Q-AC*Q=15*50(0,05*50+5+225/50)*50=750-600=150
Exercise 3
• Demand is p = 32 – 2q. Find total revenue
function. When it reaches its maximum?
• Answer:
• TR = (32 – 2q)q = -2q2 +32q
• TR is at its maximum when Ed = -1, which is
exactly at the half-point of a linear demand:
32 – 2q = 0
Q = 16, half-point: q = 8
TR(8) = -128 + 256 = 128
Oligopoly
• Oligopoly is a market structure where there are only few
sellers and many buyers.
• Demand is falling
• Sellers can affect price, but les than monopolist. This
interaction is analyzed using game theory
• Oligopolist used to compete with prices, today with
promotion and differentiation
• Pure oligopolies (homogeneous product) and differentiated
oligopolies
• Duopoly: the simplest oligopoly (only two players)
• Price is greater than in perfect competition, smaller than
monopolistic price
Game theory
•
•
•
•
Players choose between options
Depending on decision of others they have different outcomes (profits)
John Nash won a Nobel prize for analysis of game theory
Nash Equilibrium: nobody can improve its position without change in the
opponents decision
• Dominant strategy: a company chooses 1 option no matter what the other
does
• Maximin strategy: traditional (risk averse) strategy
• Simultaneous or sequential games
Company B
Cheap product
Company A
Cheap
product
Quality
product
Quality product
100
100
350
300
320
400
50
50
Maximin strategy: (100, 100)
Nash equilibria: blue
No dominant strategy
If A has advantage: (400, 100)
If B has advantage: (300, 350)
Cooperative strategy: (300, 350)
Exercise 4
• Air transport compaines’ shares in the USA in 1986 are
given with the following table:
Company
United
American
Delta
Eastern
Northwest
TWA
Pan Am
Other
Market share
17
14
12
12
9
8
7
21
a) Find C4 concentration ratio.
b) Find HHI indeks (be careful – “the others” should not be put into
the index)
a)
• C4 = P1+P2+P3+P4
• Shares should be sorted from biggest to
smallest!
• C4 = 17 + 14 + 12 + 12
• C4 = 55%
• Four major air transport companies account
for 55% of the American airlines market.
b)
• HHI = P12 + P22 + … Pn2
• HHI = 172+152+122+122+92+82+72
• HHI = 967 out of 10000
=> Low concentration
Monopolistic competition
• Many sellers, no barriers for entry
• Differentiated product
• In the short run companies behave like
monopolists and earn extra profit
• In the long run newcomers offer substitutes
=> demand declines, profits fall to zero (p =
AC)
Short run equilibrium in monopolistic
competition
P
• Equilibrium similar to monopolistic
(MR = MC)
• Extra profit (grey).
MC
M
AC
DWL
MR
0
P = AR
Q
Long run equilibrium in monopolistic
competition
P
MC
AC
• In the long run demand becomes more
elastic because of the new companies
• MR = MC, P = AC (no profit)
• Monopolistic equilibrium (M) worse
than perfectly competitive (E) because
consumers pay more for less goods in
mon.comp.
M
DWL
E
MR
0
P = AR
Q
20
Exercise 5
• Monopolistically competitive company
maximizes profit at TR=40 Its marginal
revenue is MR=10 and MC=6+0.5Q. If it
maximizes profit, what is the optimal price,
quantity and MC? If it is a long-run
equilibrium what is the value of total cost?
•
•
•
•
•
•
•
MR=MC
10=6+0,5Q
Q=8
TR=P*Q
40=P*8
P=5
TC = 40 since in the long run profits are zero
Risk and uncertainty
• Speculation is the activity of moving goods
from places and times of abundancy to places
and times of scarcity
• Speculation improves alocation and brings
markets to equilibrium
• Arbitrage is the activity of simulatenous
purchase on one market and sale on the other
(riskless speculation)
• Hedging is a process of risk neutralization
• Person is RISK AVERSE if loss displeasure is
stronger than gain pleasure
• Person is RISK FRIENDLY if gain pleasure is
stronger than loss displeasure
• Person is RISK NEUTRAL if it regards gains as
positive as losses negative.
• Insurance spreads risk among many insurance
contractees (moral hazard – insurance fraud)
Exercise 6
Discuss individuals’ position towards risk:
• Agatha would pay 1000$ for the insurance from
loss of 10000$ that occurs in 5% of the cases.
• Ben would pay no more than 1000$ for the
insurance from loss of 10000$ that occurs in 20%
of the cases.
• Max would pay 1000$ for the insurance from loss
of 10000$ that occurs in 10% of the cases.
• Agatha: averse, Ben: friendly, Max: neutral