Imperfect Competition Chapter 9

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Imperfect CompetitionChapter 9

• LIPSEY CHRYSTAL
• ECONOMICS 12e

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Learning Outcomes

• Concentration of production varies between
  industries, but firms in all intermediate
  industry types have some power to influence
  price.
• In industries where there are many producers but
  of different products, free entry will tend to
  eliminate profits in the long run.

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Learning Outcomes

• Where there is a small group of dominant
  producers (oligopoly), strategic interaction is
  important because the market form of one is
  affected by what its rivals do.
• Insights into the choices available and the
  nature of outcomes can be achieved using game
  theory.
• Oligopoly can be associated with pure profits in
  the long run if there are barriers to entry.

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INTRODUCTION - IMPERFECT COMPETITION

• Imperfectly Competitive Market Structures
• Firms in market structures other than perfect
  competition face negatively sloped demand curves
  and must administer their prices.

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INTRODUCTION - IMPERFECT COMPETITION

• Monopolistic Competition
• In the theory of large-group monopolistic
  competition, many firms compete to sell
  differentiated products.
• Each may make pure profits in the short run. In
  the long run, freedom of entry shifts its demand
  curve until it is tangent to the ATC curve,
  leading to excess capacity and production at
  average costs above the minimum possible level.
  

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INTRODUCTION - IMPERFECT COMPETITION

• Oligopoly
• Competitive behaviour among oligopolists may lead
  to a non-cooperative equilibrium.
• It is self-policing in the sense that no one has
  an incentive to depart from it unilaterally.
• The prisoners dilemma game is a case in point.

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INTRODUCTION - IMPERFECT COMPETITION

• Oligopoly
• Oligopolistic profits can persist only if there
  are entry barriers.
• Natural barriers include economies of large-scale
  production and large fixed costs of entering the
  market.
• Artificial barriers include brand proliferation
  and high levels of advertising.

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INTRODUCTION - IMPERFECT COMPETITION

• Oligopoly as a Game
• Small-group interaction can be analysed using a
  game theory framework, which sets out the
  available actions and the payoffs under various
  actions.
• In a Nash equilibrium each firm is doing the best
  it can, given the choices that other firms have
  made.
• A co-operative solution is likely to be the one
  that maximizes joint profits, but each firm will
  typically have an incentive to cheat, and
  explicit co-operation between firms may be
  proscribed by competition law.

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INTRODUCTION - IMPERFECT COMPETITION

• Dynamics of Oligopoly Industries
• In qualitative terms the workings of the
  allocative system under oligopoly are similar
  but not identical to what they are under
  perfect competition.
• Oligopolistic industries appear to have
  contributed much more to the technological
  changes that underlie the long-run growth of
  productivity than have perfectly competitive
  industries.

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i Equilibrium of a Typical Firm in Monopolistic
Competition
MC
per unit
ATC
Es
ps
D
MR
qs
Output
I. Short-run equilibrium
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(i) Short run equilibrium for a firm in
monopolistic competition

• A typical monopolistically competitive firm is
  shown in short-run equilibrium is at point ES.
• Output is qs, where MC MR, price is ps.
• Profits are the blue area.

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ii Equilibrium of a Typical Firm in
Monopolistic Competition
MC
per unit
ATC
EL
pL
pc
D
MR
qL
qc
Output
ii. Long-run equilibrium
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(ii) Long run equilibrium of a firm in
monopolistic competition

• Here the firm is in long-run equilibrium at point
  EL.
• Entry of new firms has pushed the existing firms
  demand curve to the left until the curve is
  tangent to the firms ATC curve at output qL.
• Price is pL, and total costs are just being
  covered. Excess capacity is qC-qL.
• If the firm did produce at capacity, its costs
  would fall from pL per unit of output to pC.

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The Oligopolists Dilemma to Co-operate or to
Compete
As output
One-half monopoly output
Two-thirds monopoly output
One-half monopoly output
20
20
15
22
Bs output
Two-thirds monopoly output
17
22
15
17
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The Oligopolists Dilemma to Co-operate or to
Compete

• The figure gives a payoff matrix for a two-firm
  duopoly game.
• As production is indicated across the top. Its
  profits (in millions of pounds) are shown in the
  yellow circles within each square.
• Bs production is indicated down the left side.
• Its profits (in millions of pounds) are shown in
  the green circles within each square.
• For example, the top right square tells us that
  if B produces one-half, while A produces
  two-thirds, of the output that a monopolist would
  produce
• As profits will be 22 million
• while Bs will be 15 million

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The Oligopolists Dilemma to Cooperate or to
Compete

• If A and B co-operate, each produces one-half the
  monopoly output, and earns profits of 20 million
  as shown in the upper left box.
• In this co-operative solution, either firm can
  raise its profits by producing two-thirds of the
  monopoly output, provided that the other firm
  does not do the same.
• Now let A and B behave non-cooperatively.
• A reasons that whether B produces either one-half
  or two-thirds of the monopoly output, As best
  output is two-thirds.
• B reasons similarly.
• As a result, they reach the non-cooperative
  equilibrium.
• Here each produces two-thirds of the monopoly
  output, and each makes less than it would if the
  two firms co-operated.

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The Prisoners Dilemma
Johns plea
Innocent
Guilty
J no sentence W severe sentence
J light sentence W light sentence
Innocent
Williams plea
J severe sentence W no sentence
J medium sentence W medium sentence
Guilty
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The Prisoners Dilemma

• Two prisoners are interrogated separately.
• They are told
• if they both plead innocent, they will get a
  light sentence.
• If one pleads innocent while the other pleads
  guilty, the one who claims innocence will get a
  heavy sentence while the other will be let off.
• If both plead guilty, they will both get a medium
  sentence.
• The pay off matrix shows these conditions.

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The Prisoners Dilemma

• Both prisoners reason as follows
• (1) if the other pleads innocent I am better off
  to plead guilty and get off.
• (2) if the other pleads guilty I am better off to
  plead guilty and get only a medium sentence.
• So the optimal non-cooperative strategy for both
  is to plead guilty
• This gives them a medium sentence rather than the
  light sentence that they would get if they were
  allowed to consult and agree that both would
  plead innocent.