Chapter 9 Market structure and imperfect competition David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 7th Edition, McGraw-Hill, 2003 Power Point presentation by Alex Tackie

1 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 –recognizes its output price depends on the quantity of goods produced and sold

2 Imperfect competition An oligopoly –an industry with a few producers –each recognizing 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.

3 Market structure

4 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 D LAC 1 LAC 2 LAC 3 Output £

5 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...

6 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

7 Oligopoly A market with a 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

8 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 áe.g. OPEC

9 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

10 The kinked demand curve Q0Q0 P0P0 Quantity £ Consider how a firm may perceive its demand curve under oligopoly. It can observe the current price and output, but must try to anticipate rival reactions to any price change.

11 Q0Q0 P0P0 Quantity £ 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 … so demand in response to a price reduction is likely to be relatively inelastic The demand curve will be steep below P 0. D

12 The kinked demand curve (3) …but for a price increase rivals are less likely to react, so demand may be relatively elastic above P 0 so the firm perceives that it faces a kinked demand curve. D Q0Q0 P0P0 Quantity £

13 The kinked demand curve (4) Given this perception, the firm sees that revenue will fall whether price is increased or decreased, so the best strategy is to keep price at P 0. Price will tend to be stable, even in the face of an increase in marginal cost. D Q0Q0 P0P0 Quantity £

14 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

15 The Prisoners’ Dilemma Game Consider two firms in a duopoly each with a choice of producing “high” or “low” output:

16 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

17 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

18 RARA The result is the reaction function in panel (b): the larger the output firm B is expected to sell the smaller is the optimal output of A. Derivation of a firm’s reaction function MC QAQA QBQB QAQA £ MR 0 D0D0 QA0QA0 p0p0 Assuming firm B produces zero output, A faces the market demand curve D 0 and it maximizes profits by setting MR 0 = MC and producing Q A 0. p1p1 QA1QA1 MR 1 D1D1 When B produces some positive output, A faces the residual demand curve D 1,sets MR 1 = MC and produces Q A 1. p2p2 QA2QA2 MR 2 D2D2 When firm B increases its output, A sets MR 2 = MC and produces Q A 2.

19 Nash-Cournot equilibrium RARA E RBRB  Q A* Q B* QBQB QAQA R A and R B are the reaction functions for firms A and B respectively. Each shows the best each firm can do given its expectations about the other E is the Nash-Cournot equilibrium At E, each firm’s guess about its rival is correct and neither will wish to change its behaviour

20 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.

21 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

22 Summary…. The polar extremes of perfect competition and monopoly are rarely encountered in practice Imperfect competition is more the norm Economist’s used to say ‘market structure affects conduct which affects performance’

23 We now recognise that structure and conduct are determined simultaneously Potential competition can have an impact on the behaviour of incumbent firms Many business practices can be rationalised as strategic competition Summary contd