Imperfect competition
Imperfect Competition
• The spectrum of competition:
Perfect Comp. ------------- Monopoly
Monop. Comp.-- Oligopoly
• Assumptions underlying oligopoly
– Few Sellers
• Interdependence – each seller must be aware that their actions
will provoke actions by rival firms
– Differentiated versus non-differentiated products (cars
or oil
• Differentiated products leads to non-price competition through
activities such as advertising, style changes, quality
Cartels
• Explicit agreements among firms to fix output and prices
and act as a monopolist.
• Examples are OPEC, Electrical Conspiracy (Econ USA),
Shipping Cartel
• Incentive to cooperate – earn monopoly profits
• Incentive to cheat – increase individual profits if cheating
is not detected or punished.
• Sources of instability in cartels:
–
–
–
–
–
Number of Sellers
Cost differences
Potential competition
Recessions
Cheating
Cartels and Government
• Monopoly power is often granted by government
via regulation. Example Ma Bell (Econ USA).
• Other examples are shipping and the airline
industry (pre-deregulation).
• Justifications for government regulation include
infant industry and natural monopoly.
• Criticisms include decreased competition,
increased costs due to x-inefficiency and lobbying,
and regulation outlives its usefulness.
Links
• http://www.sunship.com/mideast/oil.html
• http://www.eia.doe.gov/emeu/cabs/chron.ht
ml
•
http://www.naseo.org/energy_sectors/fossil/oil/Supply_Graphs.htm#Prices,%201973-97
Measuring Market Power :
Market Concentration
• One presumption is that as the number of sellers
decreases, market power increases.
• Concentration Ratios – percentage of market share
controlled by x number of firms, most commonly
a four-firm concentration ratio
• Four-firm concentration ratio = (Sales by four
largest firms in an industry/Sales by all firms in
the industry) x 100
Concentration Ratios
Primary Copper (1992,2002)
98,95
Cigarettes
Beer
Breakfast Cereals
Motor Vehicles
Greeting Cards
Small-arms munitions
Household Refrigerators and
Freezers
93,99
90,90
85,83
84,83
84
84,89
82,82
McConnell and Brue, “Economics” and US Census
Problems with Concentration
Ratios
• Do not take into account foreign
competition
• Fail to account for potential competition.
– Contestable markets – firms are able to enter
and exit at low cost. Potential entry acts as a
limit to market power.
US Auto Industry 2001
GM
Ford
Daimler-Chrysler
Toyota
Honda
Nissan
Mitsubishi
Mazda
Subaru
Suzuki
27
24
16
10
7
4
2
2
1
.3
4 US firms
Control
67%
Japanese Firms
Control
26%
WSJ 4/4/2001 and
Carbaugh page 201
Mergers – Increasing
Concentration
• Vertical Merger – merging with a firm that
supplies inputs
• Horizontal Merger – merging with a competitor
• Conglomerate Merger –merging with firms that
are not related
• Successful mergers – Boeing and McDonnellDouglas
• Unsuccessful Mergers – AOL Time Warner
Game Theory
• Game theory is an attempt to model and
understand behavior given the presence of
interdependence
• Games have the following characteristics:
–
–
–
–
Rules
Strategies
Payoffs
Outcome
The Prisoner’s Dilemma
• Two criminals, Bill and Paul, are caught redhanded stealing a car, and will receive 2 year
sentences; however, they become suspects in a
previous bank robbery. The DA’s job is to see if
he can solve the bank robbery.
– Rules:
• Each player is held in separate rooms and cannot
communicate.
• Each is told that he is suspected of the larger crime and
– if both confess to the bank robbery, they get 5 year sentences
– if one rats on the other and the other does not confess to the bank
robbery, he gets off, and the other gets a 10 year sentence
– Strategies: Each player has two possible actions
• Confess to the bank robbery
• Do not confess to the bank robbery
– Payoffs: Two players with two outcomes  four
possible outcomes with the following payoffs
• Both confess – each get 5 year sentences
• Both deny – each get 2 year sentence
• Bill confesses and Paul denies – Bill gets off and Paul gets 10
years
• Paul confesses and Bill denies – Paul gets off and Bill gets 10
years.
Bill
BILL
Deny
Confess
5 years
P Confess
5 years
A
U
Paul
L
Deny
10 years
10 years
Off
Off
2 years
2 years
Paul – if Bill confesses I should too (5 vs 10), if Bill denies, I should
still confess (off vs 2)
Bill – if Paul confesses I should too (5 vs 10); if Paul doesn’t. I should
still confess (off vs 2)
Kinked Demand Curve Model
• Show a situation where the best situation for players is to
maintain current prices and that prices remain stable in
spite of firms with different cost structures.
• Asymmetry in price movements:
– If firm raises price, no one follows, therefore quantity demanded is
elastic
– If firm lowers price, all follow suit so the quantity demanded is
quite inelastic
• Marginal revenue curve is discontinuous and allows for
various marginal cost curves.
Kinked Demand Curve
– If the firm raises its
price above P, it faces an
elastic demand curve,
payoff low
– If the firm lowers its
price below P, it faces an
inelastic demand curve,
payoff low
Kinked Demand Curve
– Different firms can have
different MCs. As long as
they fall with in the
discontinuous MR, P will
remain stable.
– Output Effect < Price
Effect for price
movements with the
discontinuous MR curve.
– If MC increases enough,
all firms raise their prices
and the kink vanishes.
Dominant Firm Price Leadership
• A large dominant firm with lower costs that it
competitors becomes the price maker.
• A competitive fringe with many firms that are
price takers or followers.
• The dominant firm’s demand curve is the total
market demand minus the supply of the
competitive fringe.
• The dominant firm sets price and its quantity
based upon residual demand and this determines
the price for competitive firms and their supply.
(Examples OPEC).
Dominant Firm
– The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Dominant Firm’s
Demand Curve
Residual
Demand
Dominant Firm
– As long as the dominant firm has lower costs, it can act like
a monopolist over the residual demand.
Other Price Leadership Models
• Barometric price leadership - firms come to tacit
agreement to allow one firm to set the price
according to cost consideration. If cost move is
justified, others will follow and validate the price .
If not, or if some firm decides to defect, the price
change will not be validated.
• Rotating price leadership – firms come to tacit
agreement to allow the price leading firm to rotate
among key players in the industry.
Oligopoly and Efficiency
• The question whether oligopoly affects economic
welfare depends on whether or not they exercise
market power over prices and production
• In competition, the level of output produced is
where P=MC or MB=MC. Hence, net benefits to
society are maximized. Market prices as low as
possible and respond to changes in market forces.
This allows prices to help direct resource
allocation.
• In monopoly, the level of output produced is
where P>MC or MB>MC. Hence, net benefits to
society are NOT maximized. Market prices are
higher and respond to changes in market forces.
This allows prices to help direct resource
allocation.
• In oligopoly, the level of output is somewhere
between the competitive and the monopolistic
outcome. As the oligopolist produces closer to the
competitive solution, the net benefits to society
move closer to being maximized. The opposite is
true if the outcome moves closer to the monopoly
outcomes, such as occurs with a perfect carte.
• Non-price competition, such as advertising and
product differentiation, can negatively affect
resource allocation, but it can also contribute to
efficiency. People have different preferences for
products and advertising can help inform
consumers about the price and nature of a product.
• If prices are sticky, they can also cause
inefficiency by failing to act as signals for
resource allocation.
• The extent of these inefficiencies are the subject of
debate among economists and non-economists.
Market Structures: Monopolistic
Competition
Imperfect Competition
• The spectrum of competition:
Perfect Comp. ------------- Monopoly
Monop. Comp.-- Oligopoly
• Assumptions underlying Monopolistic
Competition
– Differentiated products
• Differentiated products leads to some market power over price
or a downward slping demand curve
– Many buyers and sellers
– Free entry and exit
– Perfect knowledge
Short-run Vs. Long-run Supply
Decisions
• In the short-run, the firm is able to set prices like a
monopolistic. P>MR so MR=MC implies that
P>MC. A firm can make profits, breakeven or
make losses.
• In the long-run, free entry and exit will eliminate
economic profits or losses.
• In either case, the monopolistically competitive
firm produces a level of output where LRAC are
greater than LRAC minimum or the efficient scale
and sets price above MC.
Monopoly Competition and
Economic Welfare
• Compared to competitive markets, monopolistic
competition results in an output level where there
is
– Excess capacity – LRAC >LRAC min
– P>MC - or MB>MC
– So, Deadweight Welfare Loss exists
• Welfare loss is due to product differentiation
– If differentiation is real, the welfare is small
– If differentiation is the result of advertising which does
not contribute anything to consumer satisfaction, it
represents welfare loss
Advertising
• Advertising is costly, the question is - does it add
anything of value to the consumer?
– informative advertising which contributes to
competition
– Advertising aimed at creating perceived differences or
brand loyalty
– Breakfast cereals and kids versus supermarket ads
• Advertising and the prisoner’s dilemma – selfcanceling ads.