Imperfect Competition
Shades of Gray between
Perfect Competition
and Monopoly
Microeconomics - Dr. Dennis Foster
The Spectrum of Competition
Firms are primarily distinguished from each other
by the degree of competition they face:
Perfect
Competition
Monopoly
Monopolistic
Competition
Contestable
Markets
Oligopoly
Game Theory
Cartels
Contestable Markets
There may be many firms …
-- but, probably only a few.
 This market appears to be an oligopoly …
-- but, there aren’t significant barriers to entry.
 In the long run, price must equal marginal cost …
-- so, firms are allocatively efficient.
 In the long run, price must equal average cost …
-- so, firms only earn a “normal” profit.


Examples – Airlines, wine production …
Monopolistic Competition
Market structure when there are:



many firms,
no barriers to entry,
each produces a “differentiated product.”
Examples: Restaurants, Convenience stores, Barbers

Differentiation may be by location!

Substitutes are not perfect.

Advertising may contribute.
Monopolistic Competition
Characteristics and Consequences

Many sellers & easy entry
- Can only earn economic profit in SR.
- In LR, must earn only normal profit.

Sells differentiated products
- Faces a downward sloping demand.
- Can raise price without losing all customers.
Monopolistic Competition
price
MC
P*
ATC
P**
ATC*
d
d**
MR**
quantity
q** q *
MR
While economic profits may be earned in the short run,
the entry of new firms will compete them away.
Monopolistic Competition
price
MC
ATC
P**
d**
MR**
quantity
q**
While economic profits may be earned in the short run,
the entry of new firms will compete them away.
Monopolistic Competition & Efficiency

Allocatively inefficient?
- Yes, since demand slopes down, P>MC.

Productively inefficient?
- Yes!!! Must be. [Excess Capacity Theorem]

Social waste of resources?
- No, as there are no econ profits to protect.

X-inefficiency?
- Unlikely, due to competition.
Oligopoly
Market structure where:
(i) there are a few dominant firms
Price
MC
D2
(ii) there are high barriers to entry
P*
D1
quantity
Q*
MR
OligOpOly …
characteristics

Few sellers
- face downward sloping demand,
- actions are interdependent.

Homogeneous or differentiated products
- steel, oil, concrete, diamonds
- cigarettes, cereal, tires, soap

Barriers to entry
- can earn economic profit in long run.
OligOpOly …
barriers to entry

Control of resource

Scale economies

Brand proliferation

Legal barriers

Deterrence strategies
- price wars
- switching costs
- game theory
OligOpOly …
models of behavior
Graphical
analyses

Kinked Demand

Price Leader

Cartel Model

Entry-limit Pricing

Contestable Markets

Game Theory
Descriptive
analyses
Oligopoly – Kinked Demand
Price
MC
D2
P*
D1
 Presumes excess capacity

quantity
Q*
MR
- Others follow price reduction.
- Nobody follows price increase.
Price rigidity in the face of changing costs
Oligopoly – Other Models
 Price Leader
- One firm sets the price; others follow.
- To be enforceable, this firm should
dominate the market (Saudi Arabia).
- Sometimes it is just by convention (Ford).

Entry-limit pricing
- Firms set price so any new entrant will
force price down below ATC.
- This is a barrier to entry.

Contestable Markets
Oligopoly - Efficiency

Allocatively inefficient?
- Yes, since demand slopes down, P>MC.

Productively inefficient?
- It is not certain, but likely.

Social waste of resources?
- Yes, as there are likely to be economic
profits to protect.

X-inefficiency?
- Yes, especially if the market is regulated.
Oligopoly – Cartel Model
Price
P**
MC
ATC
P*
demand
MR
 Firms collude

Q**
Q*
quantity
- Try to act as if it were a monopoly.
- Must increase excess capacity – incentive to cheat.
BOAPW – Be the only one not to join!
Oligopoly – Cartel Model
 Free rider problem.
- Non members get advantage of higher price
without having to control output.

Raising profits encourages entry!
- OPEC and . . . Mexico/North Sea/Alaska

There must be few substitutes.
- A cartel for coffee?

Must be able to deter cheating by members.
- Libya and oil; Iran & Iraq and oil.
- Diamonds (DeBeers) and distribution/stocks
Game Theory
Models of oligopoly behavior
based on the characteristic of
Read Chapter 24
for more on
Game Theory.
interdependence.

Cooperative vs. Noncooperative

Dominant strategy

Sequential games

Games with Nash equilibrium
Game Theory

First-mover game

Last-mover game

Chicken game

Prisoner’s Dilemma
Game Theory
The Prisoners’ Dilemma
Should Bud and Miller advertise
during the Super Bowl?
Bud
Advertise
Don't Advertise
Miller
Advertise
$100
Don't Advertise $50
$100
$200
$200
$50
$150
$150

The best outcome (for them) is . . .

But, each has the same “best” strategy . . .

How can these firms overcome the PD?
The Spectrum of Competition
Firms are primarily distinguished from each other
by the degree of competition they face:
Perfect
Competition
Monopoly
Monopolistic
Competition
Contestable
Markets
Oligopoly
Game Theory
Cartels
Imperfect Competition
Shades of Gray between
Perfect Competition
and Monopoly
Microeconomics - Dr. Dennis Foster