Market structure and imperfect

competition

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 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

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 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.
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 Market structure
Number Ability to Entry Example
of firms affect barriers
price
Perfect competition Many Nil None Fruit stall

Imperfect competition:

Monopolistic competition Many Small None Corner shop

Oligopoly Few Medium Some Cars

Monopoly One Large Huge 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.

£ LAC2

LAC3

LAC1
D
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)
MC • Firms end up in TANGENCY
£ EQUILIBRIUM, making
normal profits.
AC
• Firms do not operate at
F minimum LAC.
P1=AC1
• Price exceeds marginal cost.
• Unlike perfect competition,
the firm here is eager to sell
D more at the going market
MR price.
Q1 Output
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 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
Consider how a firm may
£ perceive its demand curve
under oligopoly.
P0
It can observe the current
price and output,
but must try to anticipate
rival reactions to any
price change.

Q0 Quantity

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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
P0
… so demand in response
to a price reduction is likely
to be relatively inelastic.

The demand curve will

be steep below P0.
D
Q0 Quantity

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The kinked demand curve (3)
… but for a price increase
£ rivals are less likely to
react,
P0
so demand may be
relatively elastic
above P0

so the firm perceives

that it faces a kinked
D demand curve.
Q0 Quantity

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The kinked demand curve (4)
Given this perception, the
£ firm sees that revenue will
fall whether price is increased
or decreased,
P0

so the best strategy is to keep

price at P0.

Price will tend to be stable,

even in the face of an increase
D in marginal cost.
Q0 Quantity

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 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
Firm A output

High 1 1 3 0

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.

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 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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Derivation of a firm’s reaction function
£ Assuming firm B produces zero
p0 output, A faces the market demand
curve D0 and it maximises profits by
p1
setting MR0 = MC and producing
p2 QA0.
MC When B produces some positive
output, A faces the residual demand
curve D1,sets MR1 = MC and
D
MR2 MR D2 MR0 1 D0 produces QA1.
1
QB QA 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
RA B is expected to sell the smaller is
the optimal output of A.
QA2 QA1 QA0 QA
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 Nash-Cournot equilibrium
• RA and RB are the
QB reaction functions for
RA firms A and B
respectively. Each shows
the best each firm can do
given its expectations
about the other
q B* E • E is the Nash-Cournot
QB*  equilibrium
• At E, each firm’s guess
RB
about its rival is correct
q *AA* qA and neither will wish to
Q QA 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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 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.

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