© The McGraw-Hill Companies, 2008 Chapter 9 Market structure and imperfect competition David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Most markets fall between the two extremes of monopoly and 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

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 Market structure

© The McGraw-Hill Companies, 2008 The minimum efficient scale and market demand (1) 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. D LAC 1 LAC 2 LAC 3 Output £

© The McGraw-Hill Companies, 2008 The minimum efficient scale and market demand (2) If mes is small then there are more likely to be a higher number of firms. LAC_1 is like a perfectly competitive firm’s cost function, LAC_2 seems to belong to an oligopolist and LAC_3 seems to belong to a natural monopolist. D LAC 1 LAC 2 LAC 3 Output £

© The McGraw-Hill Companies, 2008 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...

© The McGraw-Hill Companies, 2008 Monopolistic Competition (1) In the short run, monopolistically competitve firm faces DD. Firm produces Q 0 where MC=MR and gets Q 0 *(P 0 -AC 0 ) super-normal profit The supernormal profits etracts more firms in the long run. This decreases the demand for the incumbent firms. The demand faced by an incumbent firm shifts to DD’. 8 Çıktı D MR AC MC AC 0 Q0Q0 P0P0 DD’

© The McGraw-Hill Companies, 2008 Monopolistic competition (2) Firms end up in TANGENCY EQUILIBRIUM, making normal profits. Firms do not operate at minimum LAC. Price exceeds marginal cost. Unlike perfect competition, the firm here is eager to sell more at the going market price. P 1 =AC 1 £ Output Q1Q1 D MR AC MC F

© The McGraw-Hill Companies, 2008 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 characterised by collusion or by non-co-operation.

© The McGraw-Hill Companies, 2008 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

© The McGraw-Hill Companies, 2008 Collusion is difficult if There are many firms in the industry The product is not standardised Demand and cost conditions are changing rapidly There are no barriers to entry Firms have surplus capacity

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 The Prisoners’ Dilemma Game Consider two firms in a duopoly each with a choice of producing ‘high’ or ‘low’ output:

© The McGraw-Hill Companies, 2008 The Prisoners’ 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.

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 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

© The McGraw-Hill Companies, 2008 Summary…. The polar extremes of perfect competition and monopoly are rarely encountered in practice. Imperfect competition is more the norm.

© The McGraw-Hill Companies, 2008 Potential competition can have an impact on the behaviour of incumbent firms. Many business practices can be rationalised as strategic competition. Summary (cont.)