© The McGraw-Hill Companies, 2005 Chapter 9 Market structure and imperfect competition David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th.
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©The McGraw-Hill Companies, 2005
Chapter 9Market structure and imperfect
competition
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward
2©The McGraw-Hill Companies, 2005
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
3©The McGraw-Hill Companies, 2005
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.
4©The McGraw-Hill Companies, 2005
Market structure
Numberof firms
Ability toaffectprice
Entrybarriers
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.
DLAC1
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
£
OutputQ1
DMR
AC
MC
F
8©The McGraw-Hill Companies, 2005
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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The kinked demand curve
Q0
P0
Quantity
£Consider how a firm may perceive its demand curve under oligopoly.
It can observe the currentprice and output,
but must try to anticipaterival reactions to anyprice change.
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Q0
P0
Quantity
£
The kinked demand curve (2)
The firm may expect rivalsto respond if it reducesits price, as this will be seenas 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 increaserivals are less likely to react,
so demand may be relatively elasticabove P0
so the firm perceivesthat it faces a kinkeddemand curve.D
Q0
P0
Quantity
£
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The kinked demand curve (4)
Given this perception, thefirm sees that revenue willfall whether price is increasedor decreased,
so the best strategy is to keepprice at P0.
Price will tend to be stable,even in the face of an increasein marginal cost.D
Q0
P0
Quantity
£
15©The McGraw-Hill Companies, 2005
Game theory: some key terms
• Game– a situation in which intelligent decisions are
necessarily interdependent.
• Strategy– a game plan describing how the player will
act or move in every conceivable situation.
• Dominant strategy– where a player’s best strategy is
independent of those chosen by others.
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The Prisoners’ Dilemma Game
Consider two firms in a duopoly each with a choice of producing ‘high’ or ‘low’ output:
Firm B output
High Low
High 1 1 3 0
F
irm
A o
utp
ut
Low 0 3 2 2
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The Prisoners’ Dilemma
• Each firm has a dominant strategy to produce high
• so they make 1 unit profit each• but they would both be better off
producing low– as long as they can be sure that the other
firm also produces low.• So collusion can bring mutual benefits• but there is incentive for each firm to
cheat.
18©The McGraw-Hill Companies, 2005
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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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
QAQB
QA
£
MR0D0
QA0
p0
Assuming firm B produces zero output, A faces the market demand curve D0 and it maximises profits by setting MR0
= MC and producing QA0.
p1
QA1
MR1
D1
When B produces some positive output, A faces the residual demand curve D1,sets MR1 = MC
and produces QA1.
p2
QA2
MR2D2
When firm B increases its output, A sets MR2 = MC and
produces QA2.
20©The McGraw-Hill Companies, 2005
Nash-Cournot equilibrium
RA
*Aq Aq
*Bq 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.)
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