Imperfect Competition

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Imperfect Competition
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Building the Bridge

• Yesterday we analysed Perfect Competition
• Many sellers (price-takers), homogeneous product,
  no barriers to entry or exit
• Outcome Pc, Qc, such that PMRMC (in the LRAC)
  ? zero profits in the LR!
• Yesterday we analysed Monopoly
• One seller (price-setter), single product,
  barriers to entry and/or exit
• Outcome PmPc, QmAC
  ? Supernormal Profits in the LR!)
• Going from PC to a Monopoly implies a welfare
  transfer from consumers to the producer and a
  loss for the society as a whole

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Today Imperfect Competition

• Perfect competition and monopoly can be seen as
  two benchmark market structures.
• In reality most markets are characterised by
  intermediate forms of market structure ?
  imperfect competition
• This raises issues concerning
• returns to scale
• the nature of products (homogeneous v
  differentiated)
• the nature of interaction ? strategic interaction
  ? game theory (Last Nobel prize was awarded to
  Game Theorists!)

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Increasing Returns to Scale Imperfect
Competition

• If an industry exhibits Increasing Returns to
  Scale, the AC falls as output increases
• Probable Outcome Imperfectly competitive
  structure, as a reduced number of firms are going
  to be in a better position to supply the whole
  market at a lower average cost
• First Mover Advantage the firm moving first
  will probably get a larger market share as it
  will exploit the economies of scale/increasing
  returns sooner

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The Nature of the Products Monopolistic
competition

• Characteristics
• Large number of firms
• Each firm produces a different variety of the
  industrys product
• Ease of entry and exit into the industry
• Each firm faces a downward sloping demand curve

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Monopolistic Competition in the Short Run
price

• Short Run
• differentiated products ?downward sloping
  D-curve
• profit max at MRMC
• P AC ? excess profits

MC
AC
P
D
MR
Q
quantity
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Monopolistic Competition in the Long Run
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Strategic Interaction Oligopoly

• Few firms, differentiated products (or not),
  barriers to entry
• Each firm must take into account the effect of
  its actions on the behaviour of rival firms
• Recognising inter-dependence raises the
  possibility of oligopoly firms coordinating their
  action and acting jointly like a monopolist
  (collusion (eg. OPEC, other cartels)
• However there may be incentives for individual
  firms to cheat on the agreement
• Tension between competition and collusion
• The study of such strategic interaction ? game
  theory

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Collusion versus Competition
price
Pm
D
ACMC
MR
quantity
Qm

• By coordinating actions firms can jointly
  produce Qm at price Pm

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Strategic Interaction The Market for
Coffee

• Brazil and Vietnam are the two largest producers
  of coffee in the World
• In 1980
• Price coffee(green Arabica coffee beans)
  USD1.50/pound
• By November 2001
• Price coffee(green Arabica coffee
  beans)USD0.46/pound.
• Why did the price drop so much?
• Increased production by a few coffee-producing
  countries. (Vietnam from 4 to 11 million bags
  between 1995 and2000. Brazil from 15 to 32 in the
  same period)

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Strategic Interaction The Market for
Coffee II

• Why dont these countries collude in order to
  keep the price of coffee at Pm, by producing Qm?

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Game Theory Some Definitions...

• A game is a situation in which actions are
  interdependent
• A strategy describes a given players move(s) in
  every possible situation
• A dominant strategy is a players best response
  independent on what the other players do
• A Nash equilibrium is where each player chooses
  her/his strategy to maximise payoff assuming all
  other players are playing their Nash equilibrium
  strategies

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Collusion V Competition Pay-off Matrix
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Collusion V Competition Pay-off Matrix

• Profits are maximised if countries collude
• However, each firm has an incentive to cheat
• The Nash equilibrium is a dominant strategy
  equilibrium, and is where firms are competing
  ? sub optimal!

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In the end, it is always about Commitment

• In order to get the firms/countries to commit to
  the agreement we need
• Firms to know that their profits are certainly
  higher if they commit than if they dont
  (discount rate plays a role)
• Punishment strategies ? if a firm cheats, it gets
  punished (credibility of the punishment)
• In repeated games, the probability of committing
  increases, as the players take into account
  possible future punishments

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To Sum Up

• Economies of Scale or Product Differentiation
  tend to produce imperfectly competitive markets
• In imperfectly competitive markets firms may have
  supernormal profits
• Firms could collude and then set the price of the
  monopolist and achieve higher profits
  butcollusion isnt incentive-consistent
• Firms have incentives to cheat and increase
  production ? end up breaking the agreement
• Collusion is bound to succeed if theres
  long-term interaction (repeated games) and if
  cheaters are punished