1. Lecture notes Prepared by Anton Ljutic

2. © 2004 McGraw–Hill Ryerson Limited Imperfect Competition CHAPTER ELEVEN

3. © 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Understand the importance and effects of product differentiation Argue the pros and cons of advertising Understand the differences between two types of imperfect competition Explain why monopolistically-competitive firms tend to have excess capacity and are unlikely to earn long-run economic profits Understand why oligopoly firms often do not engage in competitive pricing Understand why large firms are often tempted to collude and form cartels

4. © 2004 McGraw–Hill Ryerson Limited Imperfect Competition A market structure in which producers are identifiable and have some control over price Product differentiation - the attempt by a firm to distinguish its product from that of its competitors by: –Developing a recognized brand name, product logo, or packaging –Securing a superior location or developing a reputation for exceptional service –Engaging in product redevelopment and improvement –Developing an effective advertising strategy

5. © 2004 McGraw–Hill Ryerson Limited Benefits of Advertising Provides the consumer with vital information Enhances competition between firms Lowers the price of products Finances magazines and television shows

6. © 2004 McGraw–Hill Ryerson Limited Critiques of Advertising It is mostly non-informative and wasteful Encourages concentration within industries Raises prices to the detriment of the consumer

7. © 2004 McGraw–Hill Ryerson Limited Two Types of Market Structures Monopolistic competition –A market in which there are many firms who sell a differentiated product and have some control over the price of the products they sell Oligopoly –A market dominated by a few large firms Concentration ratios –A measurement of the percentage of an industry’s total sales that is controlled by the largest few firms

8. © 2004 McGraw–Hill Ryerson Limited Many small firms Freedom of entry Some control over price Differentiated products Monopolistic Competition

9. © 2004 McGraw–Hill Ryerson Limited Costs, revenue Quantity MR D AC MC Economic profit Equilibrium is where MR = MC Price = P1 and Q = Q1 Total profit is: (P1 – AC) x Q1. Equilibrium is where MR = MC Price = P1 and Q = Q1 Total profit is: (P1 – AC) x Q1. Q1Q1 Monopolistically Competitive Firm in Short- Run Equilibrium P1P1 C1C1 Figure 11.2

10. © 2004 McGraw–Hill Ryerson Limited Costs, revenue Quantity MR D AC MC Equilibrium is where MR = MC Price = P2 and Q = Q1 Total Revenue = Total Cost and there are no economic profits Equilibrium is where MR = MC Price = P2 and Q = Q1 Total Revenue = Total Cost and there are no economic profits Q1Q1 The Long-Run Equilibrium for the Firm P2P2 Figure 11.3

11. © 2004 McGraw–Hill Ryerson Limited Costs, revenue Quantity MR D AC MC Equilibrium is where MR = MC Price = P2 and Q = Q3 Total Revenue < Total Cost and there are economic losses Equilibrium is where MR = MC Price = P2 and Q = Q3 Total Revenue < Total Cost and there are economic losses Q3Q3 The Effect of Too Much Entry P2P2 Figure 11.3 C3C3 Economic loss

12. © 2004 McGraw–Hill Ryerson Limited Costs, revenue MR 2 D2D2 ACMC Q MC Excess Capacity P PC Figure 11.3 P MC a b c D 1 =MR 1 Q PC Excess Long-run equilibrium for a perfectly comp. firm is a For a monopolistically comp. firm it is b Long-run equilibrium for a perfectly comp. firm is a For a monopolistically comp. firm it is b

13. © 2004 McGraw–Hill Ryerson Limited Advantages to Franchising Bulk purchasing National advertising Brand identification It allows individuals to own their own business without having to accumulate the large sums of money it would take to get started on a national level

14. © 2004 McGraw–Hill Ryerson Limited Characteristics of Oligopoly Industry It is dominated by a few large firms Entry by new firms is difficult Non-price competition between firms is widely practiced Each firm has significant control over its price Mutual interdependence exists between firms –Mutual interdependence: The condition in which a firm’s action depends on part, on the reactions of rival firms

15. © 2004 McGraw–Hill Ryerson Limited Advantages of Collusion It reduces the intensity of competition It enhances the profitability of firms It greatly reduces the risks and uncertainty firms face Colluding firms are better able to block any possible entry by new firms

16. © 2004 McGraw–Hill Ryerson Limited The Cartel It is a formal agreement of cooperation among firms It assumes the presence of collusion It is illegal in Canada and in the United States OPEC is a classic example of a cartel Cartels work to the advantage of their members only if there is no cheating between the participants

17. © 2004 McGraw–Hill Ryerson Limited OPEC’s Effects on World Oil Market S2S2 S1S1 P D Q $2 $8 3024

18. © 2004 McGraw–Hill Ryerson Limited Price Leadership To avoid price wars, firms often practice price leadership Firms in an industry concede the role of price leader to a single firm, usually the largest or most efficient firm The leader then monitors its cost and revenue with the long view in mind When conditions change sufficiently that a price increase seems urgent, the leader will balance the advantages of a large increase with the risks of new entry into the industry

19. © 2004 McGraw–Hill Ryerson Limited The Kinked Demand Curve Price Quantity D P1 Q1 If this firm increases price, rivals will not follow, resulting in an elastic demand above the prevailing price. If this firm decreases price, rivals will follow, resulting in an inelastic demand below the prevailing price. If this firm increases price, rivals will not follow, resulting in an elastic demand above the prevailing price. If this firm decreases price, rivals will follow, resulting in an inelastic demand below the prevailing price. Elastic D Inelastic D Figure 11.8

20. © 2004 McGraw–Hill Ryerson Limited Kinked Demand and Marginal Revenue Price Quantity D P1 Q1 The discontinuity in the MR curve is the result of the kink in the demand curve. An increase in MC to MC2 results in no change in equilibrium price or quantity. The discontinuity in the MR curve is the result of the kink in the demand curve. An increase in MC to MC2 results in no change in equilibrium price or quantity. MR MC 1 MC 2 Figure 11.9

21. © 2004 McGraw–Hill Ryerson Limited Are Oligopolies Efficient? There is no agreement in this area Some believe that oligopolies are too powerful and produce inefficiently Others take the view that oligopolies are at the cutting edge of new technology development and, in the long-run, push the average costs of production down

22. © 2004 McGraw–Hill Ryerson Limited Pricing Strategies for Firms with Market Power (I) Peak-load pricing –the seller charges a higher price when demand for its product peaks, and a lower price at other times Inter-temporal price discrimination –consumers are separated into different groups with different elasticities of demand –those with lower elasticities are sold first, at higher price –some time later the price is reduced in order to appeal to those with higher demand elasticities

23. © 2004 McGraw–Hill Ryerson Limited Pricing Strategies for Firms with Market Power (II) Two-part tariff –an up-front fee for the right to buy a product is charged Mixed bundling –restaurant owners usually bundle certain products for a specific price Coupons and rebates –sellers of products offer more price sensitive customers a lower price than those who simply can’t be bothered with clipping the coupons or mailing in the rebate requests

24. © 2004 McGraw–Hill Ryerson Limited Are Firms Profit Maximizers? J.K.Galbraith: when management and ownership are divorced, profit- maximization not the only objective Other possible objectives: –Obtaining autonomy of decision-making –Developing state-of-the-art technology –High rates of growth –Social goals

25. © 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember the importance and effects of product differentiation the pros and cons of advertising the differences between two types of imperfect competition why monopolistically-competitive firms tend to have excess capacity and are unlikely to earn long- run economic profits why oligopoly firms often do not engage in competitive pricing why large firms are often tempted to collude and form cartels