Imperfect Competition Notes

Imperfect Competition

Introduction

• The model of imperfect competition helps understand competition in markets with many sellers and significant product variety.

Characteristics of Imperfect Competition

• Many Sellers: More than one, less than infinity.
• Differentiated Products: Firms compete on quality, price, and marketing.
• No Barriers to Entry or Exit: Firms can enter or exit the market with zero transaction costs.
• Information as a Feature of Products: Customers are informed about the product, its differences, and how it helps them.

Entry and Exit

• There are no barriers to entry in imperfect competition.
• Firms cannot make an economic profit in the long run.

Product Differentiation

• Firms compete on:
  • Price
  • Quality
  • Marketing
  • Design
  • Reliability
  • Service
  • Packaging
• Examples: Southwest, Orangina

Short Run

• Firms operate like single-price monopolies.
• Produce quantity where marginal revenue (MR) equals marginal cost (MC).
• Sell that quantity at the highest possible price.
• Make an economic profit when price (P) is greater than average total cost (ATC) (P > ATC).
• Economic Loss: If P < ATC at the profit-maximizing quantity, there is an economic loss.

Long Run

• Economic profit attracts new firms with substitute products, reducing existing firms' market share.
• Firm-specific demand decreases, leading to:
  • A decrease in the quantity where MR = MC.
  • Lower prices the firm can charge.
  • Increased ATC.
  • Decreased economic profits.
• Entry continues until firms earn zero economic profit (P = ATC).
• In the long run, firms in imperfect competition earn zero economic profit.

Imperfect Competition Equilibrium

• In the long-run equilibrium, a firm makes zero economic profit.
• Price equals Average Total Cost.

Differences with Perfect Competition

• Excess Capacity: Firms produce less than the quantity where ATC is minimized.
• Markup: Price exceeds marginal cost (P > MC).
• Price Setting: Firms are price setters.

Excess Capacity

• Firms operate with excess capacity in the long-run equilibrium.
• Produce less than the efficient scale.
• ATC is not at its minimum.

Markup

• Firms operate with a positive markup: P > MC

Perfect Competition Comparison

• Firms in perfect competition have no excess capacity and no markup.
• The perfectly elastic demand curve drives this result.
• Price equals Marginal Cost and quantity is at the lowest point on the ATC curve.

Efficiency

• In the long run, firms in imperfect competition produce less than the efficient quantity.
• People value product variety, which has a cost.
• The loss from producing less than the efficient quantity is offset by the gain from greater product variety.
• The efficient degree of product variety is where marginal benefits equal marginal cost.
• Product differentiation results in excess capacity and markup.

Innovation

• Firms must be innovative and develop new products to make economic profits.
• New product development allows a firm to gain a competitive edge temporarily before competitors imitate.
• Innovation and new products can create a series of short-run economic profits.
• Firms in Imperfect Competition do not make economic profits in the long run.

Innovation and Cost

• Firms compete by creating new products, features, materials, combinations, and business models.
• Innovation is costly but can increase total revenue.
• Firms balance the costs and benefits of innovation where $MC = MR$.
• There is an optimal amount of innovation.

Marketing, Selling, and Advertising

• Firms use marketing, selling, and advertising to ensure customers know how their product is different or better.
• A portion of the price covers the cost of selling.
• Marketing, selling, and advertising expenditures may:
  • Increase costs
  • Increase demand

Advertising Costs Implications

• With no advertising, a firm sells 10 units at an ATC of $30.
• Investments in marketing, advertising, and selling might lower the ATC by increasing equilibrium output and spreading fixed costs over a larger quantity.
• With advertising, a firm sells 20 units at an ATC of $25. Advertising increases cost, but the firm produces a larger output at a lower point on the higher ATC curve.
• Marketing can reduce markup. With no marketing, demand is less elastic, and the markup is large. Marketing makes demand more elastic. Quantity increases, price falls, and markup decreases.
• Firms spend over $1 trillion on marketing (6-14% of revenue) to provide information about value, quality, and consistency.
• Familiarity with a brand increases the likelihood of a positive predisposition toward the company and its products.

The World's Most Valuable Brands

• Lists the most valuable brands in 2021, determined by financial value and brand contribution.

Information as an Economic Resource

• Information has economic value.
• There are costs and benefits to information.
• Information becomes part of the product or service.
• The information content of different products varies.

Imperfect Competition Summary

• Many Sellers
• Differentiated Products
• No Barriers to Entry/Exit Exist
• Imperfect Information - Products are differentiated.
• Firms compete on product quality, price, and marketing.
• In the short run, output is where $MC = MR$, but the price is set at a higher amount (like a monopoly): Firms make economic profit.
• In the long run, no economic profits because of entry & exit, but firms do not produce at the lowest Average Total Cost.
• Imperfect competition is efficient because people value variety and differentiation. The higher costs of less than efficient scale are offset by the benefits of variety.
• Firms spend money on innovation to create variety and marketing to inform customers about their differentiation.