Imperfect Competition Chapter 9

1. Imperfect CompetitionChapter 9 LIPSEY & CHRYSTAL ECONOMICS 12e

2. 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.

3. 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.

4. 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.

5. 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.

6. 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 prisoner’s dilemma game is a case in point.

7. 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.

8. 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.

9. 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.

10. [i] Equilibrium of a Typical Firm in Monopolistic Competition MC £ per unit ATC Es ps D MR qs Output [I]. Short-run equilibrium

11. (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.

12. [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

13. (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 firm’s demand curve to the left until the curve is tangent to the firm’s 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.

14. The Oligopolist’s Dilemma: to Co-operate or to Compete A’s output One-half monopoly output Two-thirds monopoly output One-half monopoly output 20 20 15 22 B’s output Two-thirds monopoly output 17 22 15 17

15. The Oligopolist’s Dilemma: to Co-operate or to Compete • The figure gives a payoff matrix for a two-firm duopoly game. • A’s production is indicated across the top. Its profits (in millions of pounds) are shown in the yellow circles within each square. • B’s 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: • A’s profits will be £22 million • while B’s will be £15 million

16. The Oligopolist’s 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, A’s 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.

17. The Prisoner’s Dilemma John’s plea Innocent Guilty J light sentence W light sentence J no sentence W severe sentence Innocent William’s plea J severe sentence W no sentence J medium sentence W medium sentence Guilty

18. The Prisoner’s 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.

19. The Prisoner’s 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.