1. Imperfect Competition Economics 101

2. Imperfect Competition  Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.  Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

3. Types  Types of Imperfectly Competitive Markets  Monopolistic Competition  Many firms selling products that are similar but not identical.  Oligopoly  Only a few sellers, each offering a similar or identical product to the others.

4. Monopolistic Competition

5. Definition  Monopolistic Competition  Many firms selling products that are similar but not identical.  Markets that have some features of competition and some features of monopoly.

6. Attributes  Attributes of Monopolistic Competition  Many sellers  Product differentiation  Free entry and exit

7. Attribute 1  Many Sellers  There are many firms competing for the same group of customers.  Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

8. Attribute 2  Product Differentiation  Each firm produces a product that is at least slightly different from those of other firms.  Rather than being a price taker, each firm faces a downward-sloping demand curve.

9. Attribute 3  Free Entry or Exit  Firms can enter or exit the market without restriction.  The number of firms in the market adjusts until economic profits are zero.

10. Short-Run Economic Profits  The Monopolistically Competitive Firm in the Short Run  Short-run economic profits encourage new firms to enter the market. This:  Increases the number of products offered.  Reduces demand faced by firms already in the market.  Incumbent firms ’ demand curves shift to the left.  Demand for the incumbent firms ’ products fall, and their profits decline.

11. Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Profit- maximizing quantity Price Demand MR ATC (a) Firm Makes Profit Average total cost Profit MC

12. Short-Run Economic Losses  The Monopolistically Competitive Firm in the Short Run  Short-run economic losses encourage firms to exit the market. This:  Decreases the number of products offered.  Increases demand faced by the remaining firms.  Shifts the remaining firms ’ demand curves to the right.  Increases the remaining firms ’ profits.

13. Copyright©2003 Southwestern/Thomson Learning Demand Quantity 0 Price Loss- minimizing quantity Average total cost (b) Firm Makes Losses MR Losses ATC MC

14. Long-Run Equilibrium  Firms will enter and exit until the firms are making exactly zero economic profits.

15. Copyright©2003 Southwestern/Thomson Learning Quantity Price 0 Demand MR ATC MC Profit-maximizing quantity P =ATC

16. Characteristics of Long-Run Equilibrium  Two Characteristics  As in a monopoly, price exceeds marginal cost.  Profit maximization requires marginal revenue to equal marginal cost.  The downward-sloping demand curve makes marginal revenue less than price.  As in a competitive market, price equals average total cost.  Free entry and exit drive economic profit to zero.

17. Monopolistic versus Perfect Competition  There are two noteworthy differences between monopolistic and perfect competition — excess capacity and markup.

18. Excess Capacity  Excess Capacity  There is no excess capacity in perfect competition in the long run.  Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm.  There is excess capacity in monopolistic competition in the long run.  In monopolistic competition, output is less than the efficient scale of perfect competition.

19. Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand (a) Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) (b) Perfectly Competitive Firm MC ATC MC ATC MR Efficient scale P Quantity produced Quantity produced = Efficient scale

20. Markup  Markup Over Marginal Cost  For a competitive firm, price equals marginal cost.  For a monopolistically competitive firm, price exceeds marginal cost.  Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.

21. Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand (a) Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) (b) Perfectly Competitive Firm Markup MC ATC MC ATC MR Marginal cost P Quantity produced Quantity produced

22. Copyright©2003 Southwestern/Thomson Learning Quantity 0 Price Demand (a) Monopolistically Competitive Firm Quantity 0 Price P=MCP=MR (demand curve) (b) Perfectly Competitive Firm Markup Excess capacity MC ATC MC ATC MR Marginal cost Efficient scale P Quantity produced Quantity produced = Efficient scale

23. Monopolistic Competition and Welfare of Society  Monopolistic competition does not have all the desirable properties of perfect competition.  There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost.

24. Monopolistic Competition and Welfare of Society  However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.  Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ ideal ” one. There may be too much or too little entry.

25. Advertising  When firms  Sell differentiated products  At price above marginal cost  Then, they have incentive to advertise  To attract more buyers 25

26. Oligopoly and Game Theory

27. Key Feature  Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

28. Characteristics  Characteristics of an Oligopoly Market  Few sellers offering similar or identical products  Interdependent firms  Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

29. Simple Type: Duopoly  A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.  Duopoly  Oligopoly with only two members  Decide quantity to sell  Price – determined on the market  By demand

30. 30 The Demand Schedule for Water

31. Production Decisions  For a perfectly competitive firm  Price = marginal cost  Quantity = efficient  For a monopoly  Price > marginal cost  Quantity < efficient quantity 31

32. Markets with a few Sellers  Duopoly  Collude and form a cartel  Act as a monopoly  Total level of production  Quantity produced by each member  Don’t collude – self-interest  Difficult to agree; Antitrust laws  Higher quantity; lower price; lower profit  Not competitive allocation  Nash equilibrium 32

33. Collusion and Cartel  The duopolists may agree on a monopoly outcome.  Collusion  An agreement among firms in a market about quantities to produce or prices to charge.  Cartel  A group of firms acting in unison.

34. Is Cartel Possible?  Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

35. The Equilibrium for an Oligopoly  A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

36. The equilibrium for an Oligopoly  When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.  The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

37. Size of an Oligopoly  How increasing the number of sellers affects the price and quantity:  The output effect: Because price is above marginal cost, selling more at the going price raises profits.  The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

38. Size of an Oligopoly  As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.  The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

39. Strategic Action  Because the number of firms in an oligopolistic market is small, each firm must act strategically.  Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

40. Game Theory  Game theory is the study of how people behave in strategic situations.  Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

41. Prisoners’ Dilemma  The prisoners ’ dilemma provides insight into the difficulty in maintaining cooperation.  Often people (firms) fail to cooperate with one another even when cooperation would make them better off.  The prisoners ’ dilemma is a particular “ game ” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

42. Copyright©2003 Southwestern/Thomson Learning Bonnie’ s Decision Confess Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Clyde goes free Bonnie goes free Clyde gets 20 years gets 1 yearBonnie Clyde gets 1 year Remain Silent Remain Silent Clyde’s Decision

43. Dominant Strategy  The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.  Dominant strategies in Prisoners ’ dilemma: _ Clyde: Confess _ Bonnie: Confess

44. Nash Equilibrium & Best Outcome  Nash Equilibrium (self-interest): _ Clyde: Confess & Bonnie: Confess  Best Outcome (cooperation): _ Clyde: Silent & Bonnie: Silent  Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

45. Game Example: OPEC  Iraq and Iran: Members of OPEC  Their decisions on oil production.  Decisions: High Production or Low Production

46. Copyright©2003 Southwestern/Thomson Learning Iraq’s Decision High Production High Production Iraq gets $40 billion Iran gets $40 billion Iraq gets $30 billion Iran gets $60 billion Iraq gets $60 billion Iran gets $30 billion Iraq gets $50 billion Iran gets $50 billion Low Production Low Production Iran’s Decision

47. Nash Equilibrium  Dominant strategies: _ Iran: High Production _ Iraq: High Production  Nash Equilibrium (self-interest): _ Iran: High Production & Iraq: High Production  Best Outcome (cooperation): _ Iran: low production & Iraq: low production

48. Game Example: Where to Advertise?  Players: Competitor.com or We.com  Decisions: NBA and NHL

49. No Nash equilibrium in pure strategies Where to advertise?

50. No Nash Equilibrium  Dominant strategies: _ We.com: none _ Competitor.com: none Nash Equilibrium (self-interest): _ We.com: none _ Competitor.com: none

51. Game Example: Evening News  Players: ATV and TVB  Decisions: 7:30 pm or 8:00 pm

52. Evening News:

53. Nash Equilibrium  Dominant strategies: _ ATV: none _ TVB: none Two Nash Equilibria (self-interest): _ ATV: 7:30pm & TVB: 8:00pm or _ ATV: 8:00pm & TVB: 7:30pm

54. Why People Sometimes Cooperate  Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one- time gain.

55.  Repeated prisoners’ dilemma  Encourage cooperation  Penalty for not cooperating  Better strategy  Return to cooperative outcome after a period of noncooperation  Best strategy: tit-for-tat  Player - start by cooperating  Then do whatever the other player did last time  Starts out friendly  Penalizes unfriendly players  Forgives them if warranted 55

56. Public Policy Toward Oligopolies  Controversies over antitrust policies  Most commentators agree that price-fixing agreements among firms should be illegal. Yet the antitrust laws have been used to condemn some business practices whose effects are not obvious. There are three examples of controversial business practice:  Resale price maintenance  Predatory pricing  Tying

57. Resale price maintenance  Resale price maintenance (fair trade)  Require retailers to charge customers a given price  Might seem anticompetitive  Prevents the retailers from competing on price  Defenders:  Not aimed at reducing competition  Legitimate goal: Prevent from free rider problem

58. Example  Superduper sells disc players to retailers for $100.  Require retailers to charge customers a given price, say $150.  Might seem anticompetitive  Prevents the retailers from charging less than $150  Defenders:  Superduper would be worse off if its retailers were a cartel, so it is not aimed at reducing competition.  Legitimate goal of resale price maintenance  Without resale price maintenance, some customers would take advantage of one store’s service, and then buy the item at a discount retailer. Resale price maintenance prevents from free rider problem.

59. Public Policy Toward Oligopolies  Predatory pricing  Charge prices that are too low  Anticompetitive  Price cuts may be intended to drive other firms out of the market  Skeptics  Predatory pricing – not a profitable strategy  Price war - to drive out a rival  Prices - driven below cost

60. Example  Coyote Air has a monopoly on some route. Roadrunner Express enters and takes 20% of the market.  Coyote’s anticompetitive move: slashing its fare.  The price cut (predatory pricing) of Coyote intends to drive Roadrunner out of the market. Prices have to be driven below cost.  Coyote sells cheap tickets at a loss, and low fares attract more customers. Therefore, Coyote had better be ready to fly more planes. Meanwhile, Roadrunner can respond to Coyote’s predatory pricing by cutting back on flights. As a result, Coyote ends up bearing more losses.  The predator suffers more than the prey.

61. Public Policy Toward Oligopolies  Tying  Offer two goods together at a single price  Expand market power  Skeptics  Cannot increase market power by binding two goods together  Form of price discrimination  Tying may increase profit

62. Example  Makemoney Movie produces two films. It offers theaters the two films (Film A is a blockbuster, and Film B is art film) together at a single price.  Makemoney uses tying as a mechanism for expanding its market power.  Skeptical: forcing a theater to accept a worthless movie as part of the deal does not increase the theater’s willingness to pay. Makemoney cannot increase its market power simply by using tying.  Tying exists because it is a form of price discrimination. Suppose there are two theaters. Theater 1 is willing to pay $15000 for film A and $5000 for film B. Theater 2 is willing to pay $5000 for film A and $15000 for film B.  Pricing strategy for each film: $15000; Tying strategy for two films :$20000  Tying allows Makemoney to increase profit by charging a combined price.