IMPERFECT COMPETITION

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CHAPTER 10 IMPERFECT COMPETITION
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• Taxonomy of Market Structures
• - Competition
• - Monopoly
• Imperfect Competition
• Monopolistic Competition
• Oligopoly (few sellers)

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• Assumptions of the Model of Monopolistic
  Competition
• Large number of sellers (no mutual
  interdependence)
• Differentiated products (not homogeneous) leads
  to non-price competition and firms demand slopes
  downward
• Free entry (zero economic profits in the long
  run)
• Genealogy of model Chamberlin and Robinson

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Figure 10.1
Demand Curve Facing Monopolistically Competitive
Firm
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• Product differentiation may arise from or be
  supported by advertising. May be real or in the
  eyes of the consumer.
• Advertising may be informative, persuasive, or
  even deceptive. Provides consumers information
  about
• prices
• product quality
• availability
• attributes
• Purposes of advertising are to
• Increase demand
• Increase product differentiation (reduce
  elasticity)

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Figure 10.2
The Effects of Advertising on the Firms Demand
Curve
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• Pros and Cons of Advertising
• Pros Advertising
• Provides useful information
• Reduces search costs
• Facilitates new entry
• Cons Advertising
• Raises costs
• Misleads consumers
• Creates artificial distinctions
• Raises barriers to entry
• Lee Benhams eyeglasses study.

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Short-Run Equilibrium under Monopolistic
Competition Due to product differentiation, the
firms demand curve slopes downward, resulting
in MR lt P. Slope of firms demand (elasticity
at different prices) depends upon the degree of
product differentiation. Firm maximizes profit
by producing output level where MC MR. Note
Optimal advertising. Charges what the market
will bear. Profits may be gt,lt or to 0 in the
short run. Equilibrium looks like monopoly.
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Figure 10.3
Short-Run Profits for the Monopolistically
Competitive Firm
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Long-Run Equilibrium Under Monopolistic
Competition Assumptions of free entry requires
that profits 0 in the long run. Entry (for ?
gt 0) or exit (for ? lt 0) shifts the individual
firms demand curve in or out, respectively.
Graph. With downward-sloping demand, zero
profits require that equilibrium occurs at
tangency between demand and long-run average
cost. Note Tangency solution is maximum profit
feasible for this demand (i.e., MC MR).
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Figure 10.4
The Tangency Solution
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• Welfare Comparison of Competition Versus
  Monopolistic Competition
• Properties of Long-Run Equilibrium
• Competition Monopolistic Competition
• Prices long-run marginal cost Prices gt
  long-run marginal cost
• Prices minimum long- Prices gt minimum long-run
  average cost run average cost
• Profits zero Profits zero
• Thus, monopolistic competition leads to
• Allocative inefficiency, P gt MC
• Productive inefficiency, P gt AC min
• Defenses
• Variety is the spice of life.
• If firm demand is relatively elastic, departure
  from efficient outcomes is not large.

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DEFINITIONS OLIGOPOLY market structure in
which there are a few sellers, where few
means a number that is small enough that mutual
interdependence is recognized. - Products may
be homogeneous or differentiated - Generally
assume there are significant barriers to
entry MUTUAL INTERDEPENDENCE Each firms
profits depend upon the actions (prices, quality,
advertising, etc.) of its rivals. CARTEL an
alliance of producers formed to restrict industry
output in order to raise price and increase
profits. Synonyms collusion, price fixing, bid
rigging.
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GAME THEORY Area of mathematics and economics
concerned with decision making in situations
involving mutual interdependence and uncertainty.
Games, defense strategies, oligopoly
theory. PRISONERS DILEMMA Simple illustration
of game theory that is useful for demonstrating
the concepts of - mutual interdependence -
dominant solutions - collusive outcomes (tacit
or explicit) - backward induction - incentive
to cheat - repeated games
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Butch Cassidy and the Sundance Kid Face the
Prisoners Dilemma
Figure 11.1
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Figure 11.2
The Prisoners Dilemma and Fast-Food Contests
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• DEFINITION
• BARRIERS TO ENTRY Anything that restricts the
  ability of new firms to enter a market in which
  economic profits are being earned. Generally, a
  cost that new entrants must bear that is not
  borne by incumbents. BTEs may be natural or
  artificial
• - economies of scale
• - sunk costs
• - scarce raw material
• - government restrictions on entry
• patents
• licensing
• tariffs and quotas
• franchises

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DEFINITION MARKET POWER Ability of a firm (or
a group of firms acting in concert) to raise
price above the competitive level by a
significant amount and maintain that price for a
substantial period of time. - Market power
arises from firms having control over price
(i.e., a downward-sloping firm demand curve) and
the presence of significant barriers to entry.
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MODELS OF OLIGOPOLY EQUILIBRIUM Due to the
presence of mutual interdependence and
uncertainty, the market equilibrium under
oligopoly will depend upon firms expectations
concerning rivals reactions to their choices of
price, output, advertising, quality, and so
on. Consequently, there are many oligopoly
theories possible and oligopoly equilibrium can
range from competitive to monopoly (and anything
in between). Chapter discusses three such
models - Dominant firm - Limit pricing -
Cartel (game theory with communication)
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CARTEL MODEL Firms solve the Prisoners Dillema
problem by communication and agreement. Complete
cartel (all firms participate) results in
monopoly price and output. Joint profit
maximization. Partial conspiracy (less than all
firms participate) results in price above the
competitive level but below the monopoly level.
Graph.
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Figure 11.4
Organizing a Competitive Industry into a Cartel
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Fundamental problems faced by cartels are -
Cheating (graph) - Entry Hard to punish
cheaters cannot enforce an illegal
contract. Price cuts punish everyone. Both
problems tend to cause cartels to fall apart over
time. Section 1 of the Sherman Act (1890) makes
collusion illegal (a felony).
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Figure 11.5
Cheating in a Cartel
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Factors that facilitate collusion - Small
number of sellers - Large number of buyers -
Homogeneous product - Entry barriers -
Inelastic demand - Sealed bid auctions
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Welfare Triangle net loss in social welfare
that results from monopolization or cartelization
of an industry. Several economists have
estimated the magnitude of this loss for the U.S.
economy. Note Analysis assumes a given
technology ignores the potential impact of
monopoly power on technological innovation.
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Figure 11.6
The Effects of Competitive versus Monopolistic
Markets
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Table 11.1 Type of market Numbers of Barriers
Type of Long-Run Structure Sellers to Entry
Product Market Tendencies Pure
competition Many No Homogenous P MC P
ATC Monopolistic Many No Differentiated P gt
MC competition P ATC Oligopoly Few Yes Ho
mogenous or P gt MC Differentiated P
gtATC Cartels Relatively few, Yes Homogenous
or P gt MC acting as one Differentiated P
gtATC Pure monopoly One Yes Unique P gt
MC P gtATC