Chapter 9 Market structure and imperfect competition

1. 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. 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. 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. Market structure

5. £ LAC2 LAC3 LAC1 D Output 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.

6. 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...

7. Monopolistic competition (2) MC • 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. £ AC F P1=AC1 D MR Q1 Output

8. 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.

9. 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

10. 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

11. £ P0 Q0 Quantity The kinked demand curve 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.

12. £ P0 D Q0 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.

13. £ P0 D Q0 Quantity 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.

14. £ P0 D Q0 Quantity 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.

15. 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.

16. The Prisoners’ Dilemma Game Consider two firms in a duopoly each with a choice of producing ‘high’ or ‘low’ output:

17. 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. 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.

19. Assuming firm B produces zero output, A faces the market demand curve D0 and it maximises profits by setting MR0 = MC and producing QA0. p0 p1 p2 When B produces some positive output, A faces the residual demand curve D1,sets MR1 = MC and produces QA1. D1 D2 D0 MR2 MR0 MR1 When firm B increases its output, A sets MR2 = MC and produces QA2. 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. RA QA1 QA2 QA0 Derivation of a firm’s reaction function £ MC QB QA QA

20. QB RA E  QB* RB QA* QA Nash-Cournot equilibrium • 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

21. 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.

22. 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

23. 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’.

24. Summary (cont.) • 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.