CHAPTER 9
Market structure and imperfect competition
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Most markets fall between the two extremes of
monopoly & 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
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Imperfect competition
• An oligopoly
– an industry with 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.
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Market structure
Competition
Number of
Firms
Ability to
affect price
Entry
Barriers
Example
Perfect
Lots
Nil
None
Fruit stall
Little
Small
Corner
shop
Imperfect
Many
Monopolistic
Oligopoly
Few
Medium
Bigger
Cars
Monopoly
One
Large
Huge
Post office
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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.
£
LAC3
D
Output
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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...
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Monopolistic competition (2)
MC
£
AC
• Firms end up in TANGENCY
EQUILIBRIUM, making normal
profits.
• Firms do not operate at
minimum LAC.
F
P1=AC1
• Price exceeds marginal
cost.
• Unlike perfect competition,
MR
Q1
D
the firm here is eager to sell
more at the going market
Output
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price.
Oligopoly
• A market with 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 characterized by collusion or by
non-co-operation.
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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
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Collusion is difficult if…
• there are many firms in the industry
• the product is not standardized
• demand and cost conditions are
changing rapidly
• there are no barriers to entry
• firms have surplus capacity
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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
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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.
DD
Q0
Quantity
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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.
DD
Q0
Quantity
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The kinked demand curve (4)
Price rises will lead to a large loss of
market share. Price cuts increase
quantity only by increasing industry
sales.
Suppose the firm’s MC curve shifts
up or down by a small amount.
Since the MR curve has a
discontinuous vertical segment at
Q0, it remains optimal to leave price
unchanged.
Price will tend to be stable, even in
the face of changes in marginal
cost.
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Game theory: some key terms
• Game
– a situation in which intelligent decisions are
necessarily interdependent
• Strategy
– a game plan describing how the player will
act or move in every conceivable situation
• Dominant strategy
– where a player’s best strategy is
independent of those chosen by others
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The Prisoner’s Dilemma game
Firm B Output
HIGH
Firm A
Output
LOW
HIGH
1
1
3
0
LOW
0
3
2
2
The orange and blue numbers in each box indicate profits to
A and B respectively. Whether B pursues High or Low output,
A makes more profit going high, so does B, whatever A
adopts. In equilibrium both go high. Yet both would make
greater profits if both went low.
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The Prisoner’s Dilemma
• Each firm has a dominant strategy to produce
high, so they make 1 unit profit each.
• But they would both be better off producing low,
– as long as they can be sure that the other firm
also produces low.
• So, collusion can bring mutual benefits, but there
is incentive for each firm to cheat.
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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
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Derivation of a firm’s reaction function
£
Assuming firm B produces zero output,
A faces the market demand curve D0
and it maximizes profits by setting MR0
= MC and producing QA0.
p0
p1
p2
MC
QB
D2 D
MR2
MR1
MR0
1
D0
QA
RA
QA2QA1 QA0
QA
When B produces some positive
output, A faces the residual demand
curve D1,sets MR1 = MC and produces
QA1.
When firm B increases its output, A
sets MR2 = MC and produces QA2.
The result is the reaction function in
the lower panel: the larger the output
firm B is expected to sell the smaller is
the optimal output of A.
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Nash-Cournot equilibrium
• 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
QB
RA
QB*
• E is the Nash-Cournot
equilibrium
E

RB
QA*
QA
• At E, each firm’s guess
about its rival is correct
and neither will wish to
change its behaviour
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Contestable markets
• A contestable market is characterized by
free entry and free exit.
– no sunk costs
– allows hit-and-run entry
• Contestability may constrain incumbent
firms from exploiting their market power.
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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
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Concluding comments (1)
• Imperfect competition exists when individual firms
believe they face downward-sloping demand
curves.
• Pure monopoly status can be conferred by
legislation, as when an industry is nationalized or a
temporary patent is awarded.
• A natural monopoly may result if the minimum
efficient scale is large enough relative to the
industry demand curve.
• Monopolistic competitors face free entry to and
exit from the industry but are individually small and
make similar though not identical products.
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Concluding comments (2)
• Oligopolists face tension between collusion to
maximize joint profits and competition for a larger
share of smaller joint profits.
• Game theory analyses interdependent decisions in
which each player chooses a strategy.
• In the Cournot model each firm treats the output of
its rival as given.
• In the Bertrand model each firm treats the price of
its rival as given.
• A firm with a first-mover advantage acts as a
Stackelberg leader.
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