Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 11 Imperfect Competition and Strategic Behavior

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Describe how most industries have either a large number of small firms or a small number of large firms. 3. Describe the key elements of the theory of monopolistic competition. 2. Describe how imperfectly competitive firms have differentiated products and often engage in nonprice competition. 4. Explain why strategic behavior is a key feature of oligopoly. 5. Use game theory to explain the difference between cooperative and noncooperative outcomes among oligopolists.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Industries with Many Small Firms About 2/3 of total U.S. output is produced by industries made up of relatively small firms. The structure of the U.S. Economy The perfectly competitive model does well in explaining the behavior of some industries (e.g., forest and fish products) but not others, even though they contain many small firms.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Industries with a Few Large Firms About 1/3 of U.S. output is produced by industries dominated by either a single firm or a few large ones. Most modern industries that are dominated by large firms contain several firms. These are not competitive markets. Examples: Electric utilities, cable TV service, and some government-owned corporations, such as Amtrak.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Industrial Concentration The concentration ratio measures economic power in an industry and shows the market shares of a specific number of the industry’s largest firms. Defining a market with reasonable accuracy is difficult. Sometimes the market is much smaller than the whole country. Other times, it is much larger than the whole country. Due to globalization, a lone firm in one Canadian industry may be competing with foreign firms operating in Canada.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 11.1 Four-firm concentration Ratios in Selected U.S. Industries

Copyright © 2008 Pearson Addison-Wesley. All rights reserved What is imperfect competition? Firms Choose Their Products A differentiated product: a group of products that are similar enough to be called the same product but different enough that they can be sold at different prices. Most firms in imperfectly competitive markets sell differentiated products: - laundry soaps, beer, cars, running shoes

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Firms Choose Their Prices Typically, firms administer prices, and so are price setters. Firms often let output vary in response to fluctuations in demand to avoid costs of changing prices (unless the changes in demand are expected to persist). The costs of changing prices include the costs of printing new price lists and the loss of customer goodwill.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Nonprice Competition Imperfectly competitive firms typically engage in behavior that is absent in either monopoly or perfect competition: firms often spend large sums of money on advertising firms often engage in nonprice competition firms may create entry barriers to prevent erosion of current pure profits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Two Market Structures The above discussion applies to imperfectly competitive market structures. Industries with a large number of small firms — the theory of monopolistic competition. Industries with a small number of large firms — the theory of oligopoly (which involves game theory). A key difference: strategic behavior displayed by firms.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Monopolistic Competition The Assumptions of Monopolistic Competition 1. Each firm produces one variety of the differentiated product. Thus, it faces a negatively sloped and highly elastic demand curve. 2. The industry contains so many firms that each one ignores competitors when making price and output decisions. 3. Firms are free to enter and exit the industry.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 11.2 Profit Maximization for a Firm in Monopolistic Competition

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In contrast to perfect competition, the LR equilibrium in monopolistic competition does not minimize ATC — there is excess capacity. This excess capacity may not mean waste if consumers value product variety. Society faces a tradeoff between product variety and lower cost per unit. Monopolistic Competition vs. Perfect Competition

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Empirical Relevance of Monopolistic Competition The theory of monopolistic competition is useful for analyzing industries with low concentration ratios and differentiated products: - restaurants - clothes - hair stylists - mechanics

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Oligopoly and Game Theory Oligopoly: an industry containing two or more firms, at least one of which produces a significant portion of the industry’s total output. An oligopolistic firm faces only a few competitors. Strategic behavior is central to their actions.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Basic Dilemma of Oligopoly Oligopolistic firms will make more joint profits if they cooperate, or collude. But each individual firm may make more profits if it “cheats.” How could firms reach a cooperative outcome to maximize their joint profits? Game theory is used to study decision making in such situations — each player takes account of the others’ expected reactions when making a move.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The players are firms, their strategies are the price or output decisions, and their payoffs are profits. Consider a simplified duopoly in which two firms choose to cooperate or compete: Compete: produce 2/3 of the monopoly output – yields high output and low price Cooperate: produce 1/2 of the monopoly output – yields low output and high price Some Simple Game Theory

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 11.3 The Oligopolist’s Dilemma: To Cooperate or to Compete?

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Note that for each firm, the best action is to “compete,” no matter what the other firm is doing. So in this game, the Nash equilibrium has both firms “competing” and producing the higher level of output. A Nash equilibrium is an outcome in which each firm is doing the best it can given what the other firm is doing. Nash Equilibrium

Copyright © 2008 Pearson Addison-Wesley. All rights reserved One-half monopoly output Two-thirds monopoly output A’s output One-half monopoly output Two-thirds monopoly output B’s output Cooperative Outcome Nash equilibrium But notice that this outcome does not maximize joint profits – this is the classic example of the prisoner’s dilemma! Prisoner’s Dilemma

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Once in a Nash equilibrium, no firm has an incentive to unilaterally alter its own behaviour. The basis of a Nash equilibrium is rational decision-making in the absence of cooperation. EXTENSIONS IN THEORY 11.1 The Prisoners’ Dilemma Nash Equilibrium

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Types of Cooperative Behavior When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion. explicit collusion occurs when firms formally agree - DeBeers and OPEC cooperation without explicit agreement is called tacit collusion. Oligopoly in Practice

Copyright © 2008 Pearson Addison-Wesley. All rights reserved firms may compete for market share firms may offer secret discounts to increase sales firms may use innovation and attempt to gain advantage over rivals in the very long run Types of Competitive Behavior LESSONS FROM HISTORY 11.1 Explicit Cooperation in OPEC Competitive Behavior

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Importance of Entry Barriers In the absence of natural entry barriers, oligopolistic firms must create entry barriers if they are to earn profits in the long run. Brand Proliferation as an Entry Barrier A large number of differentiated products leaves a small market share available to a new firm. This is one explanation for many varieties of a product being produced by the same firm.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Advertising as an Entry Barrier Heavy advertising can force an “outside” firm to spend heavily on its own advertising. If the “outside” firm had a low MES, the new advertising costs may result in a much higher MES  deters entry.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Predatory Pricing as an Entry Barrier A firm will not enter a market if it expects continued losses after entry. The existing firm loses profits, but it also discourages potential future rivals. Existing firms can create such an expectation by keeping prices below their own costs until the entrant goes bankrupt.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Oligopoly and the Economy Temporary changes in demand lead to more price volatility in competitive markets than in oligopoly markets. Permanent changes in demand, however, lead to similar adjustments in both market structures. Oligopoly is an important market structure in modern economies because there are many industries in which the MES is simply too large to support many competing firms.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The challenge for public policy is to keep oligopolies competing and using their competitive energies to improve products and reduce costs. Oligopolists often grow through mergers or by driving rivals into bankruptcy. This process increases the size and market share of survivors, and possibly reduces the extent of competition in the market. Oligopoly and Competition