Imperfect Competition Imperfect Competition Shades of Gray between Perfect Competition and Monopoly Microeconomics - Dr. Dennis Foster

Spectrum The Spectrum of Competition Firms are primarily distinguished from each other by the degree of competition they face: Perfect Competition Monopolistic Competition Contestable Markets Oligopoly Cartels Game Theory Monopoly

Contestable Markets There may be many firms … -- but, probably only a few. This market appears to be an oligopoly … -- but, there aren’t significant barriers to entry. In the long run, price must equal marginal cost … -- so, firms are allocatively efficient. In the long run, price must equal average cost … -- so, firms only earn a “normal” profit. Examples – Airlines, wine production …

Monopolistic Competition Market structure when there are: many firms, many firms, no barriers to entry, no barriers to entry, each produces a “differentiated product.” each produces a “differentiated product.” Examples: Restaurants, Convenience stores, Barbers Differentiation may be by location! Differentiation may be by location! Substitutes are not perfect. Substitutes are not perfect. Advertising may contribute. Advertising may contribute.

Monopolistic Competition Many sellers & easy entry Sells differentiated products - Can only earn economic profit in SR. - In LR, must earn only normal profit. - Faces a downward sloping demand. - Can raise price without losing all customers. Characteristics and Consequences

Monopolistic Competition ATC MC d MR quantity price P* q* ATC* P** q** d** MR** While economic profits may be earned in the short run, the entry of new firms will compete them away. While economic profits may be earned in the short run, the entry of new firms will compete them away.

Monopolistic Competition & Efficiency Allocatively inefficient? Allocatively inefficient? - Yes, since demand slopes down, P>MC. Productively inefficient? Productively inefficient? - Yes!!! Must be. [Excess Capacity Theorem] Social waste of resources? Social waste of resources? - No, as there are no econ profits to protect. X-inefficiency? X-inefficiency? - Unlikely, due to competition.

Oligopoly Market structure where: (i) there are a few dominant firms (ii) there are high barriers to entry

Oligopoly … characteristics Few sellers interdependent Few sellers - face downward sloping demand, - actions are interdependent. Homogeneous or differentiated products Homogeneous or differentiated products - steel, oil, concrete, diamonds - cigarettes, cereal, tires, soap Barriers to entry Barriers to entry - can earn economic profit in long run.

Oligopoly … barriers to entry Control of resource Control of resource Scale economies Scale economies Brand proliferation Brand proliferation Legal barriers Legal barriers Deterrence strategies Deterrence strategies - price wars - switching costs - game theory

Oligopoly … models of behavior Kinked Demand Kinked Demand Price Leader Price Leader Cartel Model Cartel Model Entry-limit Pricing Entry-limit Pricing Contestable Markets Contestable Markets Game Theory Game Theory Graphical analyses Descriptive analyses

Presumes excess capacity Presumes excess capacity - Others follow price reduction. - Nobody follows price increase. Price rigidity in the face of changing costs Price rigidity in the face of changing costs Oligopoly – Kinked Demand MR quantity Price P* Q* D2D2 D1D1 MC

Price Leader Price Leader - One firm sets the price; others follow. - To be enforceable, this firm should dominate the market (Saudi Arabia). - Sometimes it is just by convention (Ford). Entry-limit pricing Entry-limit pricing - Firms set price so any new entrant will force price down below ATC. - This is a barrier to entry. Contestable Markets Contestable Markets Oligopoly – Other Models

Allocatively inefficient? Allocatively inefficient? Productively inefficient? Productively inefficient? Social waste of resources? Social waste of resources? X-inefficiency? X-inefficiency? Oligopoly - Efficiency - It is not certain, but likely. - Yes, since demand slopes down, P>MC. - Yes, as there are likely to be economic profits to protect. - Yes, especially if the market is regulated.

Firms collude Firms collude - Try to act as if it were a monopoly. - Must increase excess capacity – incentive to cheat. BOAPW – Be the only one not to join! BOAPW – Be the only one not to join! Oligopoly – Cartel Model demand MR P* Q* MC ATC P** Q** Price quantity

Free rider problem. Free rider problem. - Non members get advantage of higher price without having to control output. Raising profits encourages entry! Raising profits encourages entry! - OPEC and... Mexico/North Sea/Alaska There must be few substitutes. There must be few substitutes. - A cartel for coffee? Must be able to deter cheating by members. Must be able to deter cheating by members. - Libya and oil; Iran & Iraq and oil. - Diamonds (DeBeers) and distribution/stocks Oligopoly – Cartel Model

Models of oligopoly behavior based on the characteristic of interdependence. Game Theory Cooperative vs. Noncooperative Cooperative vs. Noncooperative Dominant strategy Dominant strategy Sequential games Sequential games Games with Nash equilibrium Games with Nash equilibrium Read Chapter 24 for more on Game Theory.

First-mover game First-mover game Last-mover game Last-mover game Chicken game Chicken game Prisoner’s Dilemma Prisoner’s Dilemma Game Theory

Should Bud and Miller advertise during the Super Bowl? The Prisoners’ Dilemma $100 $200 $50 $150 The best outcome (for them) is... The best outcome (for them) is... But, each has the same “best” strategy... But, each has the same “best” strategy... How can these firms overcome the PD? How can these firms overcome the PD? Game Theory

Spectrum The Spectrum of Competition Firms are primarily distinguished from each other by the degree of competition they face: Perfect Competition Monopolistic Competition Contestable Markets Oligopoly Cartels Game Theory Monopoly

Imperfect Competition Imperfect Competition Shades of Gray between Perfect Competition and Monopoly Microeconomics - Dr. Dennis Foster