Imperfect Competition Part V

1. Chapter 11 Imperfect Competition (Part V) © 2004 Thomson Learning/South-Western

2. Monopolistic Competition • Entry still may reduce profits to zero, but production at minimum cost is not assured. • Monopolistic competition is a market in which each firm faces a negatively sloped demand curve and there are no barriers to entry. • This type of market is illustrated in Figure 11.5.

3. FIGURE 11.5: Entry Reduces Profitability in Oligopoly Price, costs d mr AC MC P* 0 Quantity per week q*

4. Monopolistic Competition • Initially the demand curve is d, marginal revenue is mr, and q* is the profit-maximizing output level. • If entry is costless, the entry shifts the firm’s demand curve inward to d’ where profits are zero. • At output level q’, average costs are not minimum, and qm - q’ is excess capacity.

5. FIGURE 11.5: Entry Reduces Profitability in Oligopoly Price, costs d mr AC MC d’ P* P’ mr’ 0 Quantity per week q’ q* qm

6. Sustainability of Monopolistic Competition • Monopolistic competition focuses only on the behavior of actual entrants but ignores the effects of potential entrants. • A broader perspective of the “ invisible hand” is the distinction between competition in the market and competition for the market.

7. Determination of Industry Structure • Let q* represent that output level for which average costs are minimized. • Let Q* represent the total market for the commodity when price equals market (and average) cost. • The number of firms, n, in the industry (which may be relatively small) is given by

8. Determination of Industry Structure • As shown in Figure 11.6, for example, only four firms fulfill the market demand Q*. • The contestability assumption will ensure competitive behavior even though firms may recognize strategic relationships among themselves. • The potential for entrants constrains the types of behavior that are possible.

9. FIGURE 11.6: Contestability and Industry Structure Price AC AC AC AC 2 3 4 1 P* D Quantity per week 0 q* 2* 3* Q* = 4* q q q

10. APPLICATION 11.4: Airline Deregulation Revisited • Airlines Contestability • Since planes are mobile, they can be moved into a market that promises excess profits. • Such potential entry should hold prices at competitive levels even with few firms. • However, terminal facilities are market specific and brand loyalty appears to exist. • Also, some major airports have limited potential for growth.

11. APPLICATION 11.4: Airline Deregulation Revisited • Effects of Deregulation • Studies suggest that fares declined after deregulation with one study suggesting yearly gains to customers of about $8.6 billion. • However, this study found that additional welfare gains of about $2.5 billion were not realized because of the limitations of landing slots and computer reservations systems may aid in price collusion among major airlines.

12. APPLICATION 11.4: Airline Deregulation Revisited • Trend in Airline Competition • Many new airlines entered after the 1978 deregulation, but they were often consolidated into larger carriers. • Several existing airlines went out of business. • The hub-and-spoke designs of flight networks were introduced which has lead to dominance of one or two airlines in a hub city which may have resulted in higher fares.

13. Barriers to Entry • The existence of barriers to entry change the type of analysis. • In addition to those previously discussed, barriers include brand loyalty and strategic pricing. • Firms may drive out potential entrants with low prices followed later by price increases or they may buy up smaller firms.