imperfect competition in the market

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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 firm’s long-run average cost curve stops falling.
• The size of the mes relative to market demand has a
strong influence on market structure.
D
LAC1
LAC2
LAC3
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.
P1=AC1
£
Output
Q1
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
Q0
P0
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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Q0
P0
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 P0.
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 P0
so the firm perceives
that it faces a kinked
demand curve.
D
Q0
P0
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 P0.
Price will tend to be stable,
even in the face of an increase
in marginal cost.
D
Q0
P0
Quantity
£
MC1
MC2
MR

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RA
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 firm’s reaction function
MC
QA
QB
QA
£
MR0
D0
QA
0
p0
Assuming firm B produces zero
output, A faces the market demand
curve D0 and it maximises profits by
setting MR0 = MC and producing
QA
0.
p1
QA
1
MR1
D1
When B produces some positive
output, A faces the residual demand
curve D1,sets MR1 = MC and
produces QA
1.
p2
QA
2
MR2
D2
When firm B increases its output, A
sets MR2 = MC and produces QA
2.

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Nash-Cournot equilibrium
RA
*
A
q A
q
*
B
q E
RB

QA*
QB*
QB
QA
• RA and RB 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 firm’s 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.)