S121 ECO504 BUSINESS ECONOMICS

29/02/2016

1

OTHER TYPES OF IMPERFECT COMPETITION

Market structure II- Other types

of imperfect competition

Characteristics of Monopolistic Competition

 Monopolistic competition is a market structure in which

many firms sell products that are similar but not identical

 Characteristics

• Many sellers

• Product differentiation

• Free entry

Product Differentiation

•A firm in monopolistic competition practices product

differentiation if the firm makes a product that is slightly

different from the products of competing firms.

What Is Monopolistic

Competition?

29/02/2016

2

Monopolistic Competition

Many Sellers

•The presence of a large number of firms in the market

implies:

 Each firm has only a small market share and therefore

has limited market power to influence the price of its

product.

 Each firm is sensitive to the average market price, but no

firm pays attention to the actions of others. So no one

firm’s actions directly affect the actions of others.

 Collusion, or conspiring to fix prices, is impossible.

Entry and Exit

•There are no barriers to entry in monopolistic

competition, so firms cannot make an economic profit

in the long run.

Monopolistic Competition

 Examples of markets which have characteristics of

monopolistic competition

• Restaurants

• Computer games

• Hotel accommodation

• Beauty consultants

• Opticians

29/02/2016

3

The Monopolistically Competitive Firm in the Short Run

• The firm in panel (a) makes a profit because, at this quantity, price is

above ATC

• The firm in panel (b) makes losses because, at this quantity, price is less

than ATC

The Long-Run Equilibrium  When firms are making profits

new firms have an incentive to

enter the market

• Supply increases

• Prices fall

• Existing firms wanting to sell

more must reduce prices

• Close substitutes means

effectively the demand curve for

an individual firm shifts to the left

• Firms making loses will exit

market

• Supplies fall and prices rise

• Process continues until zero

profits are made

$ AC

MC

D

MR

Q*

P*

Quantity of Brand

X MR1

D1

Entry

P1

Q1

Long Run Equilibrium

(P = AC, so zero profits)

Long-Run Monopolistic

Competition

29/02/2016

4

Long Run: Zero Economic Profit

In the long run, economic profit induces entry.

And entry continues as long as firms in the industry earn

an economic profit—as long as (P > ATC).

In the long run, a firm in monopolistic competition

maximises its profit by producing the quantity at which its

marginal revenue equals its marginal cost, MR = MC.

Price and Output in Monopolistic

Competition

Monopolistic vs. Perfect Competition • Panel (a) shows the long-run equilibrium in a monopolistically competitive market

• Panel (b) shows the long-run equilibrium in a perfectly competitive market

• Only the perfectly competitive firm produces at the efficient scale

• Price equals marginal cost under perfect competition, but price is above marginal

cost under monopolistic competition so exerting market power

• Monopolistic competition uses of advertising and tries to establish a brand

Monopolistic Competition and Perfect Competition

•Two key differences between monopolistic competition and perfect competition are:

 Excess capacity

 Markup

•A firm has excess capacity if it produces less than the quantity at which ATC is a minimum.

•A firm’s markup is the amount by which its price exceeds its marginal cost.

Price and Output in

Monopolistic Competition

29/02/2016

5

Making the Relevant Comparison

The markup that drives a gap between price and marginal

cost arises from product differentiation.

People value product variety, but product variety is costly.

Price and Output in Monopolistic

Competition

Monopoly, monopolistic

competition and perfect

competition A monopoly firm, in contrast, can earn persistent profits

provided that source of monopoly power is not eliminated.

A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.

Oligopoly

 Oligopoly is where competition is between a few

 Duopoly is an oligopoly with just two members

Competition, Monopolies and Cartels

 Groups of firms might decide to behave like a

monopoly by agreeing between them what to

charge or what quantities to produce. They are

colluding

 The group of firms colluding is a cartel

29/02/2016

6

Game Theory Framework

 Game theory is the study of how people behave

in strategic situations.

 Games consist of the following components:

• Players or agents who make decisions.

• Planned actions of players, called strategies.

• Payoff of players under different strategy scenarios.

Overview of Games and Strategic Thinking

One-Shot Games: Theory

 Strategy

• A decision rule that describes the actions a player will

take at each decision point.

 Dominant strategy

• A strategy that is best for a player regardless of the

strategies chosen by the other players.

Simultaneous-Move, One-Shot

Games

Normal-Form Game

Player A

Player B

Strategy Left Right

Up 10, 20 15, 8

Down -10 , 7 10, 10

Set of players

Player A’s strategies

Player B’s strategies

Player A’s possible payoffs

from strategy “down”

Player B’s

possible

payoffs

from

strategy

“right”

29/02/2016

7

The Prisoners’ Dilemma  The Prisoners’ dilemma is a ‘game’ between two captured prisoners

that illustrates why cooperation is difficult to maintain even when it is

mutually beneficial

• In this game between two criminals suspected of committing a crime

• The sentence that each receives depends both on his decision whether to

confess or remain silent and on the decision made by the other.

A dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other player Both Mr. Green and Mr. Blue confess and both spend 8 years in jail If they had both remained silent, both of them would have been better off

The Equilibrium for an Oligopoly

 Competition laws prohibit explicit agreements among

oligopolists

 A Nash equilibrium is a situation in which oligopolies

choose their best strategy given the strategies the others

have chosen

• Oligopolies would be better off cooperating

• Instead oligopolies choose self interest at the expense of maximizing

joint profit

Oligopolies as a Prisoner’s Dilemma  Consider an oligopoly with two firms, BP and Shell. Both firms refine crude oil

 Both firms agree to keep refined oil production low in order to keep the world

price of refined oil high

 They must now decide to stick to the agreement or ignore it

 The profit that each earns depends on both its production decision and the

production decision of the other oligopolist

• The dominant strategy is for both to ignore the agreement

and go for high production

• This is an inferior outcome than if both stuck to the agreement

The dilemma also applies to

advertising and common resources

29/02/2016

8

Games in Economics

 Repeated Game: game is played repeatedly over a period

of time

 In a perpetual repeated game, equilibria that are not stable

may become stable due to the threat of retaliation.

Restraint of Trade & Competition Law

 Designed to discourage collusion

Controversies over Competition Policy

 Resale Price Maintenance • A business may wish to protect brand image of which a high price is

part of its marketing strategy

 Predatory Pricing • Where is the boundary between predatory and competitive pricing?

 Tying • Where a customer is required to buy something they do not want as a

condition of buying something they do want