IMPERFECT COMPETITION AND MONOPOLY

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CHAPTER 9

Topics

What is imperfect competition, sources of market imperfection

4 types of market structure& oligopoly

Comparing Monopoly to perfect competition

Profit maximization condition in an imperfect competition.

What is imperfect competition?Sources of market imperfection.

4

Imperfect Competition

Perfect competition : No firm is large enough to affect the market price.

Imperfect competition: Individual sellers can affect the price of their output. (Monopoly, oligopoly, monopolistic competition)

Imperfect Competition

Firm demand under perfect competition

Firm demand under imperfect competition

6

Sources of Market Imperfection

Economies of scale

Barriers to entry

Network externalities

Economies of Scale

If economies of scale exist, a firm can decrease its average cost by expanding its output

Bigger firms will have a cost advantage over smaller firms

One or few firms will produce most of the industry’s total output →Imperfect competition

If a single firm is producing for entire market, the market is a natural monopoly

Barriers to Entry

Legal restrictions Protection of intellectual property Government franchise

High cost of entry Advertising

9

Network Externalities

Exist when an increase in network’s membership increases its value to current and potential members

When network externalities are present, joining a large network is more beneficial than joining a small network

Avoiding switching costs

What is oligopoly? 4 market structures

WHAT IS OLIGOPOLY?

Another market type that stands between perfect competition and monopoly.

Oligopoly is a market type in which: A small number of firms compete. Natural or legal barriers prevent the entry

of new firms.

WHAT IS OLIGOPOLY?

Small Number of FirmsIn contrast to monopolistic competition and

perfect competition, an oligopoly consists of a small number of firms. Each firm has a large market share The firms are interdependent The firms have an incentive to collude

WHAT IS OLIGOPOLY?

Interdependence

When a small number of firms compete in a market, they are interdependent in the sense that the profit earned by each firm depends on the firms own actions and on the actions of the other firms.

Before making a decision, each firm must consider how the other firms will react to its decision and influence its profit.

WHAT IS OLIGOPOLY?

Temptation to ColludeWhen a small number of firms share a market,

they can increase their profit by forming a cartel and acting like a monopoly.

A cartel is a group of firms acting together to limit output, raise price, and increase economic profit.

Cartels are illegal but they do operate in some markets.

Despite the attraction to collude, cartels tend to collapse.

WHAT IS OLIGOPOLY?

Barriers to EntryEither natural or legal barriers to entry can

create an oligopoly.

Natural barriers arise from the combination of the demand for a product and economies of scale in producing it.

If the demand for a product limits to a small number the firms that can earn an economic profit, there is a natural oligopoly.

WHAT IS OLIGOPOLY?

(a) shows the case of a natural duopoly.

A duopoly is a market with two firms.

Here, where price equals minimum ATC, the lowest possible price, two firms can produce the quantity demanded in the market.

WHAT IS OLIGOPOLY?

(b) shows the case of a natural oligopoly with three firms.

Here, where price equals minimum ATC, the lowest possible price, three firms can produce the quantity demanded in the market.

WHAT IS OLIGOPOLY?

Identifying OligopolyIdentifying oligopoly is the flip side of identifying

monopolistic competition.

The borderline between oligopoly and monopolistic competition is hard to pin down.

As a practical matter, we try to identify oligopoly by looking at concentration measures.

An HHI that exceeds 1,800 is generally regarded as an oligopoly.

RANGE OF OLIGOPOLY OUTCOMES

Competitive OutcomePrice equals marginal cost.Monopoly OutcomeThe firm would be a single-price monopoly.Possible Oligopoly OutcomesThe extremes of perfect competition and

monopoly provide the maximum range within which the oligopoly outcome might lie.

RANGE OF OLIGOPOLY OUTCOMES

RANGE OF OLIGOPOLY OUTCOMES

Collusion Versus CompetitionBy limiting production to the monopoly

quantity, the firms can maximize joint profits.

By increasing production, one firm might be able to make an even larger profit and force a smaller profit on to the other firm.

RANGE OF OLIGOPOLY OUTCOMES

Joint profits can be $72 million if the firms produce the monopoly output.

RANGE OF OLIGOPOLY OUTCOMES

Boeing can increase its economic profit by $4 million and cause the economic profit of Airbus to fall by $6 million.

Boeing Increases Output to 4 Airplanes a Week

16.2 RANGE OF OLIGOPOLY OUTCOMES

Airbus Increases Output to 4 Airplanes a Week

For Airbus this outcome is an improvement on the previous one by $2 million a week.

For Boeing, the outcome is worse than the previous one by $8 million a week.

RANGE OF OLIGOPOLY OUTCOMES

Boeing Increases Output to 5 Airplanes a Week

If Boeing Increases output to 5 Airplanes a week, its economic profit falls.

Similarly, if Airbus Increases output to 5 Airplanes a week, its economic profit falls.

RANGE OF OLIGOPOLY OUTCOMES

A problem: If both firms stick to the monopoly output, they

both produce 3 airplanes and make $36 million.

If they both increase production to 4 airplanes a week, they both make $32 million.

If only one increases production to 4 airplanes a week, that firm makes $40 million.

What do they do?

Game theory provides an answer.

Types of Imperfectly Competitive Markets

Oligopoly Only a few sellers, each offering a

similar or identical product to the others.

Monopolistic Competition Many firms selling products that are

similar but not identical.

The Four Types of Market Structure

Monopoly Oligopoly Monopolistic

Competition

Perfect Competitio

n

• Tap water

• Cable TV

• Tennis balls

• Crude oil

• Novels

• Movies

• Wheat

• Milk

Number of Firms?

Type of Products?

Many firms

One firm Few

firms Differentiated products

Identical products

Comparing monopoly with perfect competition.

Comparing Monopoly to Perfect Competition

In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely

But monopoly differs from perfect competition in another way Can expect a monopoly market to have a higher price

and lower output than an otherwise similar perfectly competitive market

By raising price and restricting output, new monopoly earns economic profit

Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output

Comparing Monopoly and Perfect Competition

100,000

E$10

D

S

1,000

ATCMC

d$10

Quantity of Output

Price per

Unit

(a) Competitive Market (b) Competitive FirmDollars

per Unit

Quantity of Output

2. and each firm produces 1,000 units, where P = MC.

1. In this competitive market of 100 firms, equilibrium price is $10

3. When monopoly takes over, the old market supply curve . . .

Comparing Monopoly and Perfect Competition

100,000Quantity of

Output

Price per

Unit

E10

D

(c) Monopoly

S = MC

60,000

MR

$15F

6. with a higher price and lower market output than under perfect competition.

4. becomes the monopoly's MC curve.

5. The monopoly produces where MR = MC,

Comparing Monopoly to Perfect Competition Changeover from perfect competition to monopoly benefits

owners of monopoly and harms consumers of the product Important proviso concerning this result

In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal

General conclusion Monopolization of a competitive industry leads to two opposing

effects For any given technology of production, monopolization

leads to higher prices and lower output Changes in technology of production made possible under

monopoly may lead to lower prices and higher output Ultimate effect on price and quantity depends on relative

strengths of two effects

Profit maximization condition in an imperfect competition.

Marginal Revenue

When a monopolist makes one more unit of a good he receives MR

And it costs her MC

Let’s look at MR again….

Marginal Revenue

P(Q+1)

By adding 1 unit a monopolist gains

The area is 1 wide by P high = P

Q Q+1

P(Q)

The monopolist looses

This area is the decrease in price, which is the slope of demand times Q.

So MR is the sum of the two areas

MR= P + Q (slope demand)

MR and Competition

Q Q+1

P(Q)

q

Let Q = nq. Competitor loses just q times slope and gains P whilst monopolist looses Q times slope (n times as much) and gains P. So when n is big, MR = Q/n slope+ P is approx P.

For n large

MR = Q/n slope+ P So for large n MR just collapses to P And that is why in competition p=mc.

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The Profit-Maximizing Output Level

To maximize profit, the firm should produce level of output where MC = MR and MC curve crosses MR curve from below

For a monopoly, price and output are not independent decisions But different ways of expressing the

same decision

Monopoly Price and Output Determination

E

MR10,000

MC

D

30,000

Number of Subscribers

Monthly Price per

Subscriber

40

$60

Profit and Loss

A monopoly earns a profit whenever P > ATC Its total profit at best output level equals area

of a rectangle Height equal to distance between P and ATC Width equal to level of output

A monopoly suffers a loss whenever P < ATC Its total loss at best output level equals area of

a rectangle Height equal to distance between ATC and P Width equal to level of output

Monopoly Profit and Loss

E

MR10,000

$40

MC

32

Total Profit

ATC

D

E

Total Loss

AVCATC

MR10,000

40

MC

D

$50

Dollars(a)

Number of Subscribers

Dollars(b)

Number of Subscribers

Monopolistic Competition

Monopolistic competition is a market structure with three fundamental characteristics 1. Many buyers and sellers 2. Sellers offer a differentiated product 3. Sellers can easily enter into or exit from the

market Because it produces a differentiated product, a

monopolistic competitor faces a downward-sloping demand curve When it raises its price a modest amount, quantity

demanded will decline

Monopolistic Competition in the Short-Run

Individual monopolistic competitor behaves very much like a monopoly

Key difference is this While a monopoly is the only seller in its

market, a monopolistic competitor is one of many sellers

When a monopolistic competitor raises its price, its customers have one additional option Can buy similar good from some other firm

A Monopolistically Competitive Firm in the Short Run

MR1

$70

30

250

d1

A MCATC

Dollars

Homes Serviced per Month

3. Monthly profit–$10,000–is the area of the shaded rectangle.

1.Services 250 homes per month, where MC and MR intersect . . .

2. ATC at 250 units is less than price, so profit per unit is positive.

Monopolistic Competition in the Long-Run

Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long Entry will continue to occur, and demand curve will

continue to shift leftward Under monopolistic competition, firms can earn

positive or negative economic profit in short-run But in long-run, free entry and exit will ensure that

each firm earns zero economic profit just as under perfect competition

In real world, monopolistic competitors often earn economic profit or loss in the short-run But—given enough time—profits attract new

entrants, and losses result in an industry shakeout Until firms are earning zero economic profit

A Monopolistically Competitive Firm in the Long Run

d2MR2

E

MC

$40

100 250

Dollars

Homes Serviced per Month

ATC

MR1

In the long run, profit attracts entry, which shifts the firm's demand curve leftward.

The typical firm produces where its new MR crosses MC.

d1

Entry continues until P = ATC at the best output level, and economic profit is zero.