The McGraw-Hill Companies, 2002

Imperfect competition
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Most markets fall between the two
extremes of monopoly and perfect
competition
An imperfectly competitive firm
would like to sell more at the going price
faces a downward-sloping demand curve
recognises its output price depends on the
quantity of goods produced and sold
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Imperfect competition
An oligopoly
an industry with a few producers
each recognising that its own price depends
both on its own actions and those of its rivals.
In an industry with monopolistic
competition
there are many sellers producing products that
are close substitutes for one another
each firm has only limited ability to influence its
output price.
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Market structure
Number
of firms
Ability to
affect
price
Entry
barriers
Example
Perfect competition
Imperfect competition:
Monopolistic competition
Oligopoly
Monopoly
Many
Many
Few
One
Nil
Small
Medium
Large
None
None
Some
Huge
Fruit stall
Corner shop
Cars
Post Office
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The minimum efficient scale and market
demand
The minimum efficient scale (mes) is the output at
which a firms long-run average cost curve stops falling.
The size of the mes relative to market demand has a
strong influence on market structure.
D
LAC
1

LAC
2

LAC
3

Output

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Monopolistic competition
Characteristics:
many firms
no barriers to entry
product differentiation
so the firm faces a downward-sloping demand curve
The absence of entry barriers means that profits
are competed away...
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Monopolistic competition (2)
Firms end up in TANGENCY
EQUILIBRIUM, making
normal profits.
Firms do not operate at
minimum LAC.
Price exceeds marginal cost.
Unlike perfect competition,
the firm here is eager to sell
more at the going market
price.
P
1
=AC
1


Output
Q
1

D
MR
AC
MC
F
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Oligopoly
A market with a few sellers.
The essence of an oligopolistic industry is the
need for each firm to consider how its own
actions affect the decisions of its relatively
few competitors.
Oligopoly may be characterised by collusion
or by non-co-operation.
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Collusion and cartels
COLLUSION
an explicit or implicit agreement between existing
firms to avoid or limit competition with one
another.
CARTEL
is a situation in which formal agreements between
firms are legally permitted.
e.g. OPEC
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Collusion is difficult if
There are many firms in the industry
The product is not standardised
Demand and cost conditions are changing
rapidly
There are no barriers to entry
Firms have surplus capacity
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More on collusion
The probability of cheating may be affected
by agreement or threats.
Pre-commitment
an arrangement, entered voluntarily, restricting
future options.
Credible threat
a threat which, after the fact, is optimal to carry
out.
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The kinked demand curve
Q
0

P
0

Quantity

Consider how a firm may
perceive its demand curve
under oligopoly.
It can observe the current
price and output,
but must try to anticipate
rival reactions to any
price change.
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Q
0

P
0

Quantity

The kinked demand curve (2)
The firm may expect rivals
to respond if it reduces
its price, as this will be seen
as an aggressive move
so demand in response
to a price reduction is likely
to be relatively inelastic.
The demand curve will
be steep below P
0
.
D
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The kinked demand curve (3)
but for a price increase
rivals are less likely to
react,
so demand may be
relatively elastic
above P
0

so the firm perceives
that it faces a kinked
demand curve.
D
Q
0

P
0

Quantity

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The kinked demand curve (4)
Given this perception, the
firm sees that revenue will
fall whether price is increased
or decreased,
so the best strategy is to keep
price at P
0
.
Price will tend to be stable,
even in the face of an increase
in marginal cost.
D
Q
0

P
0

Quantity

MC1
MC2
MR
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R
A

The result is the reaction function in
panel (b): the larger the output firm
B is expected to sell the smaller is
the optimal output of A.
Derivation of a firms reaction function
MC
Q
A

Q
B

Q
A


MR
0

D
0

Q
A
0

p
0

Assuming firm B produces zero
output, A faces the market demand
curve D
0
and it maximises profits by
setting MR
0
= MC and producing
Q
A
0
.
p
1

Q
A
1

MR
1

D
1

When B produces some positive
output, A faces the residual demand
curve D
1
,sets MR
1
= MC and
produces Q
A
1
.
p
2

Q
A
2

MR
2

D
2

When firm B increases its output, A
sets MR
2
= MC and produces Q
A
2
.
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Nash-Cournot equilibrium
R
A

*
A
q
A
q
*
B
q
E
R
B


Q
A*

Q
B*

Q
B

Q
A

R
A
and R
B
are the
reaction functions for
firms A and B
respectively. Each shows
the best each firm can do
given its expectations
about the other
E is the Nash-Cournot
equilibrium
At E, each firms guess
about its rival is correct
and neither will wish to
change its behaviour

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Contestable markets
A contestable market is characterised by free
entry and free exit
no sunk costs
allows hit-and-run entry
Contestability may constrain incumbent firms
from exploiting their market power.
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Strategic entry deterrence
Some entry barriers are deliberately erected
by incumbent firms:
threat of predatory pricing
spare capacity
advertising and R&D
product proliferation
Actions that enforce sunk costs on potential
entrants
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Summary.
The polar extremes of perfect competition
and monopoly are rarely encountered in
practice.
Imperfect competition is more the norm.
Economists used to say market structure
affects conduct which affects performance.
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We now recognise that structure and conduct
are determined simultaneously.
Potential competition can have an impact on
the behaviour of incumbent firms.
Many business practices can be rationalised
as strategic competition.

Summary (cont.)