Unit 8: The Theory of Imperfect Competition

Imperfect Competition Overview

• Market structure between perfect competition and monopoly.

• Firms operate as price makers, not price takers.

• Involves active competition among several firms.

Features of Imperfectly Competitive Markets

• Differentiated Products: Firms sell similar but distinct products, allowing varied pricing.

• Administered Prices: Firms set their own prices rather than market forces.

• Short-Run Price Stability: Prices change infrequently due to "menu costs" and focus on non-price competition.

• Non-Price Competition: Extensive use of advertising, quality standards, and product guarantees.

• Unexploited Scale Economies: Firms often operate on the falling portion of their long-run average total cost curves.

• Entry Prevention: Firms engage in activities to hinder new market entrants.

Monopolistic Competition

• Definition: Many firms selling similar but non-identical products.

• Characteristics: Differentiated products, many firms (ignoring competitors' reactions), free entry and exit, symmetry (new entrants take customers equally from existing firms).

• Short-Run Equilibrium: Firms face a negatively sloped, elastic demand curve. Profit is maximized where Marginal Revenue ($MR$) equals Marginal Cost ($MC$). Profit or loss depends on Price ($P$) compared to Average Total Cost ($ATC$).

  • If P > ATC, profit.

  • If P < ATC, loss.

  • If $P = ATC$, zero economic profit.

• Long-Run Equilibrium: Zero economic profit ($P = ATC$). Demand curve is tangent to the $ATC$ curve. Price exceeds marginal cost (P > MC).

• Excess Capacity: Firms produce less than the quantity that minimizes $ATC$. Usually not considered a social problem due to value placed on product diversity.

• Mark-Up Over Marginal Cost: P > MC due to market power, leading to deadweight loss.

• Externalities of Entry: Product-variety externality (positive); Business-stealing externality (negative).

• Advertising:

  • Critique: Manipulates tastes, impedes competition, fosters brand loyalty.

  • Defence: Provides information, fosters competition, signals quality.

• Brand Names: Provide information about quality and incentivize firms to maintain high quality.

Oligopoly

• Definition: Few sellers offering similar or identical products, characterized by oligopolistic interdependence (firms' decisions affect competitors).

• Characteristics: Few competing firms, strategic behavior, administered prices, differentiated but similar products.

• Basic Dilemma: Cooperation vs. competition.

• Cooperative Solution: Firms collude (overtly or tacitly) to produce the monopoly output and maximize joint profits.

• Non-Cooperative Solution (Nash Equilibrium): Firms choose their best strategy given competitors' strategies, resulting in lower total profit than cooperation.

• Market Outcomes: Oligopoly quantity is greater than monopoly but less than perfect competition. Oligopoly price is less than monopoly but greater than competitive price (P > MC).

• Effect of Size: As number of sellers increases, market outcome approaches perfect competition.

  • Output effect: Increased output increases profit (as P > MC).

  • Price effect: Increased output lowers price, reducing profit.

• Types of Cooperative Behaviour:

  • Explicit Collusion: Overt agreements (cartels); difficult to sustain due to cheating incentives and legal prohibitions.

  • Tacit Collusion: Unspoken understanding to achieve cooperative equilibrium.

• Game Theory (Prisoner's Dilemma): Illustrates the difficulty of maintaining cooperation due to individual self-interest, even when mutually beneficial.

• Public Policy: Laws prevent anti-competitive behavior. Controversial practices include:

  • Resale Price Maintenance: Manufacturer restricts minimum selling price by retailers (defended as preventing free-riding on service).

  • Predatory Pricing: Drastically cutting prices to drive out competitors (economists doubt its common use).

  • Tying: Selling two products together (seen as a form of price discrimination, not necessarily reducing market power).

Imperfect Competition Overview

Imperfect competition describes a market structure positioned between perfect competition and a monopoly. In this setting, firms act as price makers rather than price takers, and there is active competition among several firms.

Features of Imperfectly Competitive Markets

Imperfectly competitive markets are characterized by several key features. Firms often sell differentiated products, meaning their offerings are similar but distinct, which allows for varied pricing strategies. Prices are typically administered by the firms themselves rather than being solely determined by market forces. Short-run price stability is common, as prices change infrequently due to factors like "menu costs" and a stronger focus on non-price competition. Non-price competition is extensively used, involving advertising, quality standards, and product guarantees. Firms frequently operate on the falling portion of their long-run average total cost curves, indicating unexploited scale economies. Additionally, firms actively engage in activities designed to prevent new market entrants.

Monopolistic Competition

Monopolistic competition involves many firms selling similar but non-identical products. Its characteristics include differentiated products, numerous firms (each ignoring competitors' reactions), free entry and exit, and symmetry, where new entrants equally draw customers from existing firms.

In the short-run equilibrium, firms face a negatively sloped, elastic demand curve. Profit maximization occurs where Marginal Revenue ($MR$) equals Marginal Cost ($MC$). A firm's profitability depends on the relationship between its Price ($P$) and Average Total Cost ($ATC$): if P > ATC, the firm makes a profit; if P < ATC, it incurs a loss; and if $P = ATC$, it breaks even.

Oligopoly

An oligopoly is defined by a few sellers offering similar or identical products, and it is characterized by oligopolistic interdependence, meaning that each firm's decisions significantly affect its competitors. Key characteristics include a small number of competing firms, strategic behavior, administered prices, and products that are differentiated yet similar.

The basic dilemma for oligopolistic firms is whether to cooperate or compete. A cooperative solution involves firms colluding, either overtly (forming cartels) or tacitly, to produce the monopoly output and maximize joint profits. However, collusion is often difficult to sustain due to individual incentives to cheat and legal prohibitions. A non-cooperative solution, often leading to a Nash Equilibrium, results when firms choose their best strategy given their competitors' strategies. This typically leads to lower total profit than if they had cooperated.

In terms of market outcomes, the quantity produced in an oligopoly is greater than in a monopoly but less than in perfect competition. The price in an oligopoly is less than a monopoly price but greater than the competitive price (P > MC).

As the number of sellers in an oligopoly increases, the market outcome increasingly approaches that of perfect competition. This is influenced by two effects: the output effect, where increased output generally increases profit because P > MC, and the price effect, where increased output lowers the market price, thereby reducing profit margins for all firms.

Types of cooperative behavior include explicit collusion, which refers to overt agreements (like cartels) that are often challenging to maintain due to cheating incentives and legal restrictions. Tacit collusion, on the other hand, involves unspoken understandings to achieve a cooperative equilibrium without formal agreements. Game Theory, particularly the Prisoner's Dilemma, effectively illustrates the inherent difficulty of maintaining cooperation due to firms' individual self-interest, even when collaboration would be mutually beneficial.

Public policy often involves laws designed to prevent anti-competitive behavior among oligopolists. However, certain practices remain controversial. Resale Price Maintenance, where manufacturers restrict the minimum selling price by retailers, is defended by some as a way to prevent free-riding on service provision. Predatory Pricing, which involves drastically cutting prices to drive out competitors, is generally doubted by economists as a commonly practiced effective strategy. Lastly, Tying, the practice of selling two products together, is often viewed as a form of price discrimination and not necessarily as a means of reducing market power.