The Concept of Imperfect Competition

• Refers to market structures between perfect competition and monopoly– In imperfectly competitive markets, there is more than

one seller, but too few to create a perfectly competitive market

– Imperfectly competitive markets often violate other conditions of perfect competition

• Such as the requirement of a standardized product or free entry and exit

• Types of imperfectly competitive markets– Monopolistic competition – Oligopoly

Monopolistic Competition

• Hybrid of perfect competition and monopoly, sharing some of features of each– A monopolistically competitive market has

three fundamental characteristics• Many buyers and sellers• Sellers offer a differentiated product• Sellers can easily enter or exit the market

Many Buyers and Sellers

• Under monopolistic competition, an individual buyer is unable to influence price he pays– But an individual seller, in spite of having many

competitors, decides what price to charge• Our assumption of many sellers, however, has

another purpose– To ensure that no strategic games will be played

among firms in market• There are so many firms, each supplying such a small part of

the market– That no one of them needs to worry that its actions will be

noticed—and reacted to—by others

Sellers Offer a Differentiated Product

• Each seller produces a somewhat different product from the others

• Faces a downward-sloping demand curve – In this sense is more like a monopolist than a

perfect competitor– When it raises its price a modest amount,

quantity demanded will decline (but not all the way to zero)

Sellers Offer a Differentiated Product

• What makes a product differentiated?– Quality of product– Difference in location

• Product differentiation is a subjective matter– A product is different whenever people think that it is

• Whether their perception is accurate or not

• Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated– This perception may be real or illusory, but economic

implications are the same in either case• Firm chooses its price

Easy Entry and Exit

• This feature is shared by monopolistic competition and perfect competition– Plays the same role in both– Ensures firms earn zero economic profit in

long-run

• In monopolistic competition, however, assumption about easy entry goes further– No barrier stops any firm from copying the

successful business of other firms

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

Figure 1: A Monopolistically Competitive Firm in the Short Run

MR1

$70

30

250

d1

A MCATC

Dollars

Homes Serviced per Month

2. and charges $70 per home.

4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.

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

3. 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

Figure 2: 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.

Excess Capacity Under Monopolistic Competition

• In long-run, a monopolistic competitor will operate with excess capacity– Will produce too little output to achieve minimum cost

per unit

• Excess capacity suggests that monopolistic competition is costly to consumers

• May tempt you to leap to a conclusion– Consumers are better off under perfect competition;

however• In order to get beneficial results of perfect competition, all

firms must produce identical output• Consumers usually benefit from product differentiation

Nonprice Competition• If monopolistic competitor wants to increase its output it can cut its

price– Move along its demand curve

• Any action a firm takes to increase demand for its output—other than cutting its price—is called nonprice competition– Examples include better service, product guarantees, free home

delivery, more attractive packaging • Nonprice competition is another reason why monopolistic

competitors earn zero economic profit in long-run• All this nonprice competition is costly

– Must pay for advertising, for product guarantees, for better staff training– Costs must be included in each firm’s ATC curve, shifting it upward

• None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run

Oligopoly

• When just a few large firms dominate a market– So that actions of each one have an important impact

on the others– Would be foolish for any one firm to ignore its

competitors’ reactions– In such a market, each firm recognizes its strategic

interdependence with others

• An oligopoly is a market dominated by a small number of strategically interdependent firms

Market Definition

• In oligopoly, a few large firms dominate market

• In many cases, common sense provides a sufficient guideline– Should broaden market definition just enough

to include all reasonably close substitutes

• In some cases, common sense isn’t definitive

Number of Firms

• Oligopoly requires that a few firms dominate the market– Even if we can agree on a market’s definition, what

number qualifies as “a few”?

• At some point, number of firms is large enough—and interdependence weak enough—that oligopoly becomes a poor description– Monopolistic competition would fit better– No absolute number at which oligopoly ends and

monopolistic competition begins

Market Domination

• Strategic interdependence requires that a few firms—whatever their number—dominate the market– Their share of market is large

• As combined market share shrinks, strategic interdependence becomes weaker

• Oligopoly is a matter of degree– Not an absolute classification

Economies of Scale: Natural Oligopolies

• When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market– A large firm—supplying a large share of the market—

will have lower cost per unit than a small firm• Since small firms can’t compete, only a few large firms

survive– Market becomes an oligopoly

• Tends to happen on its own unless there is government intervention

– Such a market is often called a natural oligopoly—analogous to natural monopoly

Reputation as a Barrier

• A new entrant may suffer just from being new– Established oligopolists are likely to have favorable

reputations

• In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry

• In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm

Strategic Barriers

• Oligopoly firms often pursue strategies designed to keep out potential competitors– Maintain excess production capacity as a signal to a

potential entrant that they could easily saturate market and leave new entrant with little or no revenue

– Make special deals with distributors to receive best shelf space in retail stores

– Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant

– Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product

Legal Barriers

• Patents and copyrights—which can be responsible for monopoly—can also create oligopolies

• Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

• Government barriers can operate against domestic entrants, too

Oligopoly vs. Other Market Structures

• Oligopoly presents the greatest challenge to economists• Essence of oligopoly is strategic interdependence

– Wherein each firm anticipates actions of its rivals when making decisions

• In order to understand and predict behavior in oligopoly markets– Economists have had to modify the tools used to analyze other

market structures and to develop entirely new tools as well• One approach—game theory—has yielded rich insights

into oligopoly behavior

The Game Theory Approach

• Game theory– An approach to modeling strategic interaction of

oligopolists in terms of moves and countermoves

• In all games—except those of pure chance, such as roulette—a player’s strategy must take account of the strategies followed by other players

• Game theory analyzes oligopoly decisions as if they were games by – Looking at the rules players must follow– Payoffs they are trying to achieve– Strategies they can use to achieve them

The Prisoner’s Dilemma

• Easiest way to understand how game theory works is to start with a simple, noneconomic example—the prisoner’s dilemma– Explains why a technique for obtaining confessions, commonly

used by police, is so often successful

• Each of four boxes in payoff matrix represents one of four possible strategy combinations that might be selected in this game– Upper left box: Both Rose and Colin confess– Lower left box: Colin confesses and Rose doesn’t– Upper right box: Rose confesses and Colin doesn’t– Lower right box: Neither Rose nor Colin confesses

Figure 3: The Prisoner’s Dilemma

Confess

Confess

Don’t Confess

Rose’s Actions

Colin gets 20 years

Rosegets 20years

Colin gets30 years

Colin gets 3 years

Colin gets5 years

Rosegets 20years

Rosegets 20years

Rosegets 20years

Colin’s Actions

Don’t Confess

The Prisoner’s Dilemma

• Regardless of Rose’s strategy Colin’s best choice is to confess– In this game, the strategy “confess” is an example of a dominant

strategy• Strategy that is best for a player regardless of strategy of other player

• Outcome of this game is an example of a Nash equilibrium—appropriately named after the mathematician John Nash, who originated the concept– Exists when each player is taking the best action—given actions

taken by other players

• As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them

Simple Oligopoly Games

• Same method used to understand behavior of Rose and Colin in prisoner’s dilemma can be applied to a simple oligopoly market

• Duopoly– Oligopoly market with only two sellers

• Assume that Gus and Filip must make their decisions independently– Without knowing in advance what the other will do

• No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy– A similar analysis from Filip’s point of view, using the red-shaded entries

of Figure 4, would tell us that his dominant strategy is the same: a low price

• Notice that outcome is a Nash equilibrium– Equilibrium price in market is the low price

Figure 4: A Duopoly Game

Confess

Confess

Don’t Confess

Filip’s Actions

Gus’s profit = $25,000

Filip’sProfit =$25,000

Gus’s profit= –$10,000

Gus’s profit= $75,000

Gus’s profit= $50,000

Filip’sProfit =$–10,000

Filip’sProfit =$75,000

Filip’sProfit =$50,000

Gus’s Actions

Don’t Confess

Oligopoly Games in the Real World

• Will typically be more than two strategies from which to choose

• Will usually be more than two players• In some games, one or more players may not

have a dominant strategy– A game with two players will have a Nash equilibrium

as long as at least one player has a dominant strategy• Whether the other has a dominant strategy or not

– When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

Oligopoly Games in the Real World

• We’ve limited the players to one play of the game– In reality, for gas stations and almost all other

oligopolies, there is repeated play• Where both players select a strategy• Observe the outcome of the trial• Play the game again and again, as long as they

remain rivals

• One possible result of repeated trials is cooperative behavior

Cooperative Behavior in Oligopoly

• In real world, oligopolists will usually get more than one chance to choose their prices

• The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once– Often, firms will evolve some form of

cooperation in the long run

Explicit Collusion

• Simplest form of cooperation is explicit collusion– Managers meet face-to-face to decide how to set prices

• Most extreme form of explicit collusion is creation of a cartel– Group of firms that tries to maximize total profits of the group as

a whole

• If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it?– Usually illegal– Penalties, if the oligopolists are caught, can be severe

• But oligopolists can collude in other, implicit ways

Tacit Collusion

• Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion

• Tit for tat– A game-theoretic strategy of doing to another player

this period what he has done to you in previous period

• However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion– Oligopolist will sometimes go further

• Attempting to punish a firm that threatens to destroy tacit cooperation

Tacit Collusion

• Another form of tacit collusion is price leadership– One firm—the price leader—sets its price and other

sellers copy that price

• With price leadership, there is no formal agreement– Rather the decisions come about because firms

realize—without formal discussion—that system benefits all of them

– Decisions include• Choice of leader• Criteria it uses to set its price• Willingness of other firms to follow

The Limits to Collusion

• Oligopoly power—even with collusion—has its limits– Even colluding firms are constrained by

market demand curve– Collusion—even when it is tacit—may be

illegal– Collusion is limited by powerful incentives to

cheat on any agreement

The Incentive to Cheat

• Go back to Gus and Filip for a moment– One way or another they arrive at high-price cooperative solution– Will the market stay there?

• Maybe, and maybe not– Problem—each player may conclude that he can do even better

by cheating– Two players would be back to noncooperative outcome based

on their dominant strategies– May be in each player’s interest to cheat occasionally

• Analyzing this sort of behavior requires some rather sophisticated game theory models– Economists are actively engaged in building them

When is Cheating Likely?

• While no firm wants to completely destroy a collusive agreement by cheating– Since this would mean a return to the noncooperative

equilibrium wherein each firm earns lower profit– Some firms may be willing to risk destroying

agreement if benefits are great enough– Suggests that cheating is most likely to occur—and

collusion will be least successful—under the following conditions

• Difficulty observing other firms’ prices• Unstable market demand• Large number of sellers

The Future of Oligopoly

• Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure– In 1932, two economists—Adolf Berle and Gardiner

Means—noted trend toward big business • Predicted the 200 largest U.S. firms would control nation’s

entire economy by 1970– Unless something were done to stop it

• Prediction has not come true– Today, there are hundreds and thousands of ongoing

businesses in United States

Antitrust Legislation and Enforcement

• Antitrust enforcement has focused on three types of actions– Preventing collusive agreements among firms

• Such as price-fixing agreements

– Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers

– Preventing mergers that would lead to harmful market domination

• Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws

• While thrust of these policies is to preserve competition– Type of competition preserved—and zeal with which policies are

applied—can shift

The Globalization of Markets

• By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market– Decreasing market dominance by a few, and increasing competition

• Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers

• Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods

• While consumers in each nation may have access to more firms, these may be larger and more powerful firms– Creating greater likelihood of strategic interaction and danger of

collusion

Technological Change

• Technological change works to increase competition by creating new substitute goods

• Can reduce barriers to entry in much the same way that globalization does– By increasing size of market

• Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize– Trend can also be seen as encouraging oligopoly– Result could be strategic interaction, or collusion, among large

national players• Finally, some technologies actually increase MES of

typical firm– Thereby encouraging formation of oligopolies

Figure 5a: Advertising in Monopolistic Competition

1,000

C

A60

100

$120

2,0006,000

B

1.Before advertising, long-run economic profit is zero.

2. In the short run, the first firms to advertise earn economic profit.

dads

dno ads

ATCads

ATCno ads

dall advertise

Dollars

Bottles of Perfume per Month

3. But in the long run, imitation and entry bring economic profit back to zero.

4. Advertising can lead to a higher price in the long run, as in this panel . . .

Figure 5b: Advertising in Monopolistic Competition

Dollars

Bottles of Perfume per Month

1,000

A60

dall advertise

dno ads

B$120

6,000

C50

2,000

dads

ATCads

ATCno ads

5. or to a lower price in the long run, as in this panel.

Using the Theory: Advertising in Monopolistic Competition and Oligopoly

• Perfect competitors never advertise and monopolies advertise relatively little– But advertising is almost always found under

monopolistic competition and very often in oligopoly

• Why?– All monopolistic competitors, and many oligopolists,

produce differentiated products

• Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle

Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition

• A monopolistic competitor advertises for two reasons– To shift its demand curve rightward (greater quantity demanded at

each price) – To make demand for its output less elastic

• So it can raise price and suffer a smaller decrease in quantity demanded

• Can summarize impact of advertising as illustrated in panel (a)– Since each firm must pay costs of advertising, and more

competitors have entered the market, Narcissus and its competitors are each earning normal economic profit—just as they were originally

• Advertising has raised the price from $60 to $100 in long- run– But this is not the only possible result

Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition

• Because you and I and everyone else is buying more perfume– Each producer can operate closer to capacity output,

with lower costs per unit– In long-run, entry will force each firm to pass cost

savings on to us

• Analysis suggests the following conclusion– Under monopolistic competition, advertising may

increase size of market, so that more units are sold• But in long-run, each firm earns zero economic profit, just as

it would if no firm were advertising• Price to consumer, however, may either rise or fall

Advertising and Collusion in Oligopoly

• Oligopolists have a strong incentive to engage in tacit collusion– But in some cases can use a simple game theory model to show

that collusion is almost certainly taking place

• Take airline industry as an example• In theory, any airline should be able to claim superior

safety– Yet no airline has ever run an advertisement with information

about its security policies or attacked those of a competitor• Airlines are playing against each other repeatedly and reach the

kind of cooperative equilibrium we discussed earlier

Figure 6: An Advertising Game

Run Safety Ads

Run Safety Ads

Don't Run Ads

United's Actions

American's ActionsDon't Run Ads

American earns low

profit

American earns high

profit

United earns very low profit

United earns low profit

American earns very

low profit

American earns

medium profitUnited

earns medium profit

United earns high profit

The Four Market Structures: A Postscript

• Different market structures– Perfect competition– Monopoly– Monopolistic competition– Oligopoly

• Market structure models help us organize and understand apparent chaos of real-world markets