Imperfect Competition Imperfect Competition Monopolistic Competition Monopolistic competition

Imperfect Competition

Imperfect Competition Monopolistic Competition

Monopolistic competition Assumptions of monopolistic competition ¡ many or several firms ¡ free entry ¡ differentiated product Equilibrium of the firm ¡ short run ÷ MR = MC

Short-run equilibrium of the firm under monopolistic competition £ MC AC Ps ACs AR = D MR O Qs Q

Monopolistic competition Assumptions of monopolistic competition ¡ many or several firms ¡ free entry ¡ differentiated product Equilibrium of the firm ¡ short run ÷ MR ¡ = MC long run ÷ MR = MC; AR = AC

Long-run equilibrium of the firm under monopolistic competition £ New firms entering the industry reduce demand for each individual firm. LRMC Price falls to PL LRAC PL ARL = DL MRL O QL Q

Monopolistic competition Assumptions of monopolistic competition ¡ many or several firms ¡ free entry ¡ differentiated product Equilibrium of the firm ¡ short run ÷ MR ¡ long run ÷ MR ¡ = MC; AR = AC under-utilisation of capacity in long run

Under-utilisation of capacity in the long run £ LRAC DL under monopolistic competition O Q 1 Q 2 Q

Monopolistic competition Limitations of the model ¡ imperfect information ¡ difficulty in identifying industry demand curve ¡ entry may not be totally free ¡ indivisibilities ¡ importance of non-price competition The public interest ¡ comparison with perfect competition

Long run equilibrium of the firm under perfect and monopolistic competition £ Higher price and lower output (excess capacity) under monopolistic competition LRAC P 1 P 2 DL under perfect competition DL under monopolistic competition O Q 1 Q 2 Q

Monopolistic competition Limitations of the model ¡ imperfect information ¡ difficulty in identifying industry demand curve ¡ entry may not be totally free ¡ indivisibilities ¡ importance of non-price competition The public interest ¡ comparison with perfect competition ¡ comparison with monopoly

Imperfect Competition Oligopoly

Oligopoly Key features of oligopoly ¡ barriers to entry ¡ interdependence of firms ¡ incentives to compete or to collude? Factors favouring collusion ¡ few firms, open with each other ¡ similar production methods; similar products ¡ significant entry barriers ¡ stable market ¡ collusion is legal

Oligopoly Collusive oligopoly: cartels ¡ equilibrium of the industry

Profit-maximising cartel £ Industry D = AR O Q

Profit-maximising cartel £ Industry profit maximised at Q 1 and P 1. Industry MC P 1 Members must agree to restrict total output to Q 1. Industry D = AR Industry MR O Q 1 Q

Oligopoly Collusive oligopoly: cartels ¡ equilibrium of the industry ¡ allocating and enforcing quotas

Oil prices Banking turmoil and onset of recession Recovery falters Continuing worries about supply and rapid growth in demand from China and India OPEC’s first quotas Iraq invades Kuwait Iraq invades Iran Revolution in Iran Yom Kippur War: Arab oil embargo First oil from North Sea Invasion of Iraq Cease-fire in Iran-Iraq war New OPEC quotas Worldwide recovery Worldwide slowdown Recession in Far East Start of global recovery

Oil prices Banking turmoil and onset of recession Recovery falters Continuing worries about supply and rapid growth in demand from China and India OPEC’s first quotas Iraq invades Kuwait Iraq invades Iran Revolution in Iran Yom Kippur War: Arab oil embargo First oil from North Sea Invasion of Iraq Cease-fire in Iran-Iraq war New OPEC quotas Worldwide recovery Worldwide slowdown Recession in Far East Start of global recovery

Oligopoly Tacit collusion ¡ price leadership ÷ dominant firm

Dominant firm price leadership £ Sall other firms Leader’s demand curve = market demand minus followers’ supply a P 1 Dleader P 2 O Dmarket b Q Division of the market between leader and followers

Dominant firm price leadership £ Sall other firms MCleader Leader maximises profit at QL, PL. PL l f t Dmarket At PL, followers supply QF. Dleader MRleader O QL QF QT Determination of price and output Q

Price leader aiming to maximise profits for a given market share £ Assume constant market share for leader AR = D market AR = D leader MR leader O Q

Price leader aiming to maximise profits for a given market share £ MC PL l t AR = D market Leader maximises profit at QL and thus sets price of PL. AR = D leader MR leader O QL QT Q

Oligopoly Tacit collusion ¡ price leadership ÷ dominant firm ÷ barometric ¡ rules of thumb Collusion and the law ¡ the role of the Competition Commission in the UK The breakdown of collusion

The incentive for a firm to produce more than its quota, or undercut the cartel’s price £ MC £ 10 is the cartel’s profit-maximising price. 12 10 8 6 AR 4 2 MR 1000 2000 The Industry 3000 Q

The incentive for a firm to produce more than its quota, or undercut the cartel’s price £ 12 MC Firm is tempted to increase output to 600. Cartel Price 10 (= MR if price remains fixed) 8 6 AR 4 2 MR 200 400 600 Firm A 800 Q

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour The Cournot model of duopoly ¡ assumption that rival will produce a given quantity

The Cournot model of duopoly £ MCA Firm A believes that firm B will produce QB 1. DM DA 1 O Quantity QB 1 (a) Firm A’s profit-maximising position

The Cournot model of duopoly £ MCA Firm A’s profitmaximising output and price are QA 1 and PA. PA 1 MRA 1 O QA 1 Quantity DM DA 1 QB 1 (a) Firm A’s profit-maximising position

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour The Cournot model of duopoly ¡ assumption that rival will produce a given quantity ¡ profit-maximising price and output for firm A ¡ reaction functions of firms A and B

The Cournot model of duopoly £ RA Firm B’s output MCA PA 1 MRA 1 O QA 1 Quantity Firm A’s reaction function for each assumed output of B Firm B’s reaction function for each assumed output of A QB 1 x RB DM DA 1 QB 1 (a) Firm A’s profit-maximising position O QA 1 Firm A’s output (b) The two firms’ reaction functions

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour The Cournot model of duopoly ¡ assumption that rival will produce a given quantity ¡ profit-maximising price and output for firm A ¡ reaction functions of firms A and B ¡ Cournot equilibrium

The Cournot model of duopoly Equilibrium at point e, where the two reaction functions cross £ RA Firm B’s output MCA PA 1 MRA 1 O QA 1 Quantity QBe QB 1 e x RB DM DA 1 QB 1 (a) Firm A’s profit-maximising position O QAe QA 1 Firm A’s output (b) The two firms’ reaction functions

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour (cont. ) The Bertrand model of duopoly ¡ assumption that rival sets a particular price ¡ equilibrium: price cutting until all supernormal profits are competed away Nash Equilibrium in the Cournot and Bertrand models

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour (cont. ) The kinked demand curve theory ¡ assumptions of the model ¡ the shape of the demand MR curves

Kinked demand for a firm under oligopoly £ Current price and quantity give one point on demand curve. P 1 O Q 1 Q

Kinked demand for a firm under oligopoly £ Assumption 1 If the firm raises its price, rivals will not D P 1 Assumption 2 If the firm reduces its price, rivals will feel forced to lower theirs too. D O Q 1 Q

Stable price under conditions of a kinked demand curve £ MR is discontinuous between a and b. P 1 a D = AR b O Q 1 Q MR

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour (cont. ) The kinked demand curve theory ¡ assumptions of the model ¡ the shape of the demand MR curves ¡ effect of a change in costs

Stable price under conditions of a kinked demand curve £ MC 2 MC 1 P 1 a D = AR b O If MC is anywhere between MC 1 and MC 2, profit is maximised at Q 1 Q MR

Oligopoly Non-collusive oligopoly: assumptions about rivals’ behaviour (cont. ) The kinked demand curve theory ¡ assumptions of the model ¡ the shape of the demand MR curves ¡ effect of a change in costs ¡ stable prices ¡ limitations of the model

Oligopoly and the public interest ¡ advantages ¡ disadvantages ¡ difficulties in drawing general conclusions Advertising and the public interest Oligopoly and contestable markets

Imperfect Competition Game Theory

Game Theory Single move or normal-form games ¡ alternative strategies: maximax and maximin ¡ single dominant strategy games

Profits for firms A and B at different prices X’s price £ 2. 00 B A £ 2. 00 Y’s price £ 1. 80 £ 5 m for Y £ 12 m for X £ 10 m each D C £ 12 m for Y £ 5 m for X £ 8 m each

Game theory Single move or normal-form games ¡ alternative strategies: maximax and maximin ¡ single dominant strategy games ÷ the prisoners’ dilemma

The prisoners’ dilemma Amanda's alternatives Not confess B A Each gets 1 year Nigel's alternatives C Nigel gets Confess 3 months Amanda gets 10 years Nigel gets 10 years Amanda gets 3 months D Each gets 3 years

Game Theory Single move or normal-form games ¡ alternative strategies: maximax and maximin ¡ single dominant strategy games ÷ the prisoners’ dilemma ÷ Nash ¡ equilibrium non-dominant strategy games

Profit possibilities for firm X

Profit possibilities for firm X

Profit possibilities for firm X

Profit possibilities for firm X

Game theory Multiple move games ¡ the importance of threats and promises ÷ credible ¡ threats the importance of timing ÷ decision trees

A decision tree ter ea s 0 Airbus 50 decides 400 sea ter 50 0 se at er B 1 Boeing decides A 40 0 s ea te 500 r B 2 Airbus decides er t a se 400 sea Boeing –£ 10 m (1) Airbus –£ 10 m Boeing +£ 30 m (2) Airbus +£ 50 m Boeing +£ 50 m (3) Airbus +£ 30 m ter Boeing –£ 10 m (4) Airbus –£ 10 m

Game Theory Multiple move games ¡ the importance of threats and promises ÷ credible ¡ threats the importance of timing ÷ decision trees ÷ first-mover advantage

Game Theory Limitations of game theory ¡ complex games with multiple players ¡ the role of individuals’ morals and attitudes Potential for cycles of collusion and competition

Imperfect Competition Price Discrimination

Price discrimination Meaning of price discrimination ¡ different prices for same product produced at same cost Types of price discrimination ¡ first degree

First-degree price discrimination P P 1 D O 200 Q

First-degree price discrimination P Additional revenue from price discrimination P 1 D O 200 Q

Price discrimination Meaning of price discrimination ¡ different prices for same product produced at same cost Types of price discrimination ¡ first degree ¡ second degree ¡ third degree

Third-degree price discrimination P P 1 D O 200 Q

Third-degree price discrimination P Additional revenue from price discrimination P 2 P 1 D O 150 200 Q

Price discrimination Conditions necessary for third degree price discrimination to operate ¡ two or more separable markets, each with different elasticities of demand ¡ monopoly power ¡ no (or limited) opportunity to resell the product

Price discrimination Profit-maximising prices and output under price discrimination ¡ first degree

Profit-maximising output under first-degree price discrimination MC £ D = MR O Q 1 Q

Price discrimination Profit-maximising prices and output under price discrimination ¡ first degree ¡ third degree

Profit-maximising output under third degree price discrimination Maximum-profit output MC 9 7 5 DY DX O 1000 MRY O MRX (a) Market X 2000 (b) Market Y MRT O 3000 (c) Total (markets X + Y)

Price discrimination Profit-maximising prices and output under price discrimination ¡ first degree ¡ third degree Advantages to the firm Price discrimination and the public interest ¡ advantages ¡ disadvantages