Imperfect Competition Economics 101 Imperfect Competition Imperfect competition

Imperfect Competition Economics 101

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.

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.

Monopolistic Competition

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.

Attributes ¡ Attributes of Monopolistic Competition Many sellers Product differentiation Free entry and exit

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.

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.

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.

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.

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

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.

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

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

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

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.

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

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.

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

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.

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

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

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.

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.

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

Oligopoly and Game Theory

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

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

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

The Demand Schedule for Water 30

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

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

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.

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.

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.

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).

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.

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.

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.

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.

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.

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

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

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.

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

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

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

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

Where to advertise? No Nash equilibrium in pure strategies

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

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

Evening News:

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

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 onetime gain.

¡ 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

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

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

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.

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

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.

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

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 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.