Chapter 15
Imperfect Competition
Chapter Overview
● Monopolistic
competition
Market in which firms can enter freely, each
producing its own brand or version of a differentiated
product.
● Oligopoly
Market in which only a few firms compete with one
another, and entry by new firms is impeded.
● Cartel
Market in which some or all firms explicitly collude,
coordinating prices and output levels to maximize
joint profits.
Market Structures
• The number of sellers
• The number of buyers
• Entry conditions
• The degree of product differentiation
Chamberlinian Monopolistic Competition
Market Structure
• Many
Buyers
• Many Sellers
• Free entry and Exit
• Product Differentiation
When firms have differentiated products, they each
face downward-sloping demand for their product
because a small change in price will not cause ALL
buyers to switch to another firm's product.
Monopolistic Competition
A monopolistically competitive market has two
key characteristics:
1. Firms compete by selling differentiated
products that are highly substitutable for one
another but not perfect substitutes.
i.e: the cross-price elasticities of demand are
large but not infinite.
2. There is free entry and exit: It is relatively
easy for new firms to enter the market with
their own brands and for existing firms to
leave if their products become unprofitable.
Equilibrium in the Short Run
Because the firm
is the only
producer of its
brand, it faces a
downwardsloping demand
curve.
Price exceeds
marginal cost
In the short run, price also exceeds
and the firm has
average cost, and the firm earns
monopoly power.
profits shown by the yellow-shaded
rectangle.
A MONOPOLISTICALLY COMPETITIVE
FIRM IN THE SHORT AND LONG RUN
In the long run,
these profits
attract new firms
with competing
brands.
The firm’s
market share
falls, and its
In long-run equilibrium, P = ATC,
so the firm earns zero profit even
demand curve
shifts downward. though it has some degree of
market power.
COMPARISON OF MONOPOLISTICALLY
COMPETITIVE EQUILIBRIUM AND PERFECTLY
COMPETITIVE EQUILIBRIUM
Under perfect
competition,
in the long
run, P = AC =
MC.
The demand curve facing the firm is
horizontal, so the zero-profit point occurs
at the point of minimum average cost.
COMPARISON OF MONOPOLISTICALLY
COMPETITIVE EQUILIBRIUM AND PERFECTLY
COMPETITIVE EQUILIBRIUM
Under monopolistic
competition, P >
MC. Thus there is a
deadweight loss, as
shown by the
yellow-shaded
area.
The demand curve
is downwardsloping, so the zero In both types of markets, entry
profit point is to the occurs until profits are driven to zero.
left of the point of
minimum average
cost.
Is monopolistic competition then a
socially undesirable market structure
that should be regulated?
The answer is NO for two reasons:
1. In most monopolistically competitive markets,
monopoly power is small.
• Usually enough firms compete, with brands that are
sufficiently substitutable, so that no single firm has
much monopoly power.
• Any resulting deadweight loss will therefore be small.
• And because firms’ demand curves will be fairly
elastic, average cost will be close to the minimum.
Is monopolistic competition then a
socially undesirable market structure
that should be regulated?
The answer is NO for two reasons:
2. Any inefficiency must be balanced against an
important benefit from monopolistic competition:
product diversity.
• Most consumers value the ability to choose among a
wide variety of competing products and brands
that differ in various ways.
• The gains from product diversity can be large and may
easily outweigh the inefficiency costs resulting
from downward-sloping demand curves.
Oligopoly
Assumptions:
• Many Buyers and Few Sellers
• Each firm faces downward-sloping
demand because each is a large producer
compared to the total market size
• There is no one dominant model of
oligopoly. We will review several.
Oligopoly
The products may or may not be differentiated
Only a few firms account for most or all of total
production.
In some cases, some or all firms earn substantial
profits over the long run because barriers to
entry make it difficult or impossible for new
firms to enter.
Examples of oligopolistic industries include
automobiles, steel, aluminum, petrochemicals,
electrical equipment, and computers.
Oligopoly
• Factors acting as barriers of entry to the market:
– 1) Scale economies may make it unprofitable for more
than a few firms to coexist in the market;
– 2) Patents or access to a technology may exclude potential
competitors;
– 3) The need to spend money for name recognition and
market reputation may discourage entry by new firms.
• In addition, firms may take strategic actions to deter
entry.
• Managing an oligopolistic firm is complicated
because pricing, output, advertising, and investment
decisions involve important strategic considerations,
which can be highly complex.
Equilibrium in the Oligopoly
•In an oligopolistic market, a firm sets price
or output based partly on strategic
considerations regarding the behavior
of its competitors.
•When a market is in equilibrium, firms are
doing the best they can and have no
reason to change their price or output.
NASH EQUILIBRIUM
● Nash equilibrium
Set of strategies or actions in which
each firm does the best it can, given its
competitors’ actions.
●
Duopoly Market in which two firms
compete with each other.
Cournot Oligopoly
Assumptions
• Firms set outputs (quantities)*
• Homogeneous Products
• Simultaneous
• Non-cooperative
*Definition: In a Cournot game, each firm sets its output
(quantity) taking as given the output level of its
competitor(s), so as to maximize profits.
Price adjusts according to demand.
Residual Demand: Firm i's guess about its rival's output
determines its residual demand.
Residual Demand
Definition: The relationship between the price
charged by firm i and the demand firm i faces is
firm is residual demand
In other words, the residual demand of firm i is
the market demand minus the amount of
demand fulfilled by other firms in the market:
Q1 = Q - Q2
Residual Demand
Price
10 units
Residual Marginal Revenue when q2 = 10
Residual Demand when q2 = 10
MC
Demand
0
q1*
Quantity
19
The Cournot Model
FIRM 1’S OUTPUT DECISION
Firm 1’s profit-maximizing output
depends on how much it thinks
that Firm 2 will produce.
If it thinks Firm 2 will produce
nothing, its demand curve is D1(0),
is the market demand curve. The
corresponding MR1(0), intersects
Firm 1’s MC1 at an output of 50
units.
If Firm 1 thinks that Firm 2 will
produce 50 units, its demand
curve, D1(50), is shifted to the left
75
5
by this amount.
Finally, if Firm 1 thinks that Firm
Profit maximization now implies an 2 will produce 75 units, Firm 1
will produce only 12.5 units.
output of 25 units.
REACTION CURVES AND COURNOT EQUILIBRIUM
between a firm’s profit-maximizing output and
the amount it thinks its competitor will produce.
Firm 1’s reaction curve shows how
much it will produce as a function of
how much it thinks Firm 2 will
produce. (The xs at Q2 = 0, 50, and
75 correspond to the examples.)
● Relationship
Firm 2’s reaction curve shows its
output as a function of how much it
thinks Firm 1 will produce.
In Cournot equilibrium, each firm
correctly assumes the amount that
its competitor will produce and
thereby maximizes its own profits.
Therefore, neither firm will move
from this equilibrium.
Profit Maximization
Profit Maximization: Each firm acts as a
monopolist on its residual demand curve,
equating MRr to MC.
MRr = MC
Best Response Function:
The point where (residual) MR = MC gives the
best response of firm i to its rival's (rivals')
actions.
For every possible output of the rival(s), we can
determine firm i's best response.
The sum of all these points makes up the best
response (reaction) function of firm i.
COURNOT EQUILIBRIUM
● Equilibrium
in the Cournot model in which each firm
correctly assumes how much its competitor will
produce and sets its own production level accordingly.
Cournot equilibrium is an example of a Nash equilibrium
(and thus it is sometimes called a Cournot-Nash
equilibrium).
In a Nash equilibrium, each firm is doing the best it can given
what its competitors are doing.
As a result, no firm would individually want to change its
behavior.
In the Cournot equilibrium, each firm is producing an
amount that maximizes its profit given what its competitor is
producing, so neither would want to change its output.
DUOPOLY EXAMPLE
The demand curve is
P = 30 − Q, and both
firms have zero
marginal cost. In
Cournot equilibrium,
each firm produces 10.
The collusion curve
shows combinations of
Q1 and Q2 that
maximize total profits.
If the firms collude and● Also shown is the competitive
share profits equally,
equilibrium, in which P = MC
each will produce 7.5. and profit is zero.
Bertrand Oligopoly (homogeneous product)
Assumptions:
• Firms set price*
• Homogeneous product
• Simultaneous
• Non-cooperative
*Definition: In a Bertrand oligopoly, each
firm sets its price, taking as given the price(s)
set by other firm(s), so as to maximize profits.
Setting Price
• Homogeneity
implies that consumers will buy
from the low-price seller.
• Further, each firm realizes that the demand that it
faces depends both on its own price and on the
price set by other firms
•
Specifically, any firm charging a higher price
than its rivals will sell no output.
•
Any firm charging a lower price than its rivals
will obtain the entire market demand.
Equilibrium
If we assume no capacity constraints and
that all firms have the same constant average
and marginal cost of c then:
For each firm's response to be a best
response to the other's each firm must
undercut the other as long as P> MC
Where does this stop? P = MC (!)
Price Competition
Price Competition with Homogeneous
Products—The Bertrand Model
Oligopoly model in which firms produce a
homogeneous good, each firm treats the price
of its competitors as fixed, and all firms decide
simultaneously what price to charge.
●
P = 30 – Q
and let MC1 = MC2 = $3
Q1 = Q2 = 9, and in Cournot equilibrium, the market
price is $12, so that each firm makes a profit of
$81.
Residual Demand Curve – Price Setting
Price
Market Demand
•
0
Residual Demand Curve
(thickened line segments)
Quantity
Price Competition with Homogeneous
Products—The Bertrand Model
Now suppose that these two duopolists compete by
simultaneously choosing a price instead of a quantity.
Nash equilibrium in the Bertrand model results in both
firms setting price equal to marginal cost: P1 = P2 = $3.
Then industry output is 27 units, of which each firm
produces 13.5 units, and both firms earn zero profit.
In the Cournot model, because each firm produces only
9 units, the market price is $12.
Now the market price is $3.
In the Cournot model, each firm made a profit;
In the Bertrand model, the firms price at marginal cost
and make no profit.
Stackelberg Model of Oligopoly
A situation in which one firm acts as a quantity
leader, choosing its quantity first, with all other
firms acting as followers.
Call the first mover the “leader” and the second
mover the “follower”.
The second firm is in the same situation as a
Cournot firm: it takes the leader’s output as given
and maximizes profits accordingly, using its residual
demand.
The second firm’s behavior can, then, be
summarized by a Cournot reaction function.
Dominant Firm Markets
A single company with an
overwhelming market share (a
dominant
firm)
competes
against many small producers
(competitive fringe), each of
whom has a small market share.
Limit Pricing – a strategy
whereby the dominant firm
keeps its price below the level
that maximizes its current profit
in order to reduce the rate of
expansion by the fringe.
The Dominant Firm Model
● Dominant
firm Firm with a large share of total sales that sets
price to maximize profits, taking into account the supply
response of smaller firms.
PRICE SETTING BY A DOMINANT
FIRM
The dominant firm sets price, and
the other firms sell all they want
at that price. The dominant firm’s
demand curve, DD, is the
difference between market
demand D and the supply of
fringe firms SF . The dominant
firm produces a quantity QD at
the point where its marginal
revenue MRD is equal to
its
The corresponding price is P*. At this price,
marginal cost MCD.
firms sell Q so that total sales equal Q .
F
T
Bertrand Competition – Differentiated
Assumptions:
Firms set price*
Differentiated product
Simultaneous
Non-cooperative
*Differentiation means that lowering price
below your rivals' will not result in capturing
the entire market, nor will raising price mean
losing the entire market so that residual
demand decreases smoothly
Price Competition with Differentiated Products
Suppose each of two duopolists has fixed costs of $20 but zero
variable costs, and that they face the same demand curves:
Firm 1’s demand:
Firm 2’s demand:
CHOOSING PRICES
Firm 1’s profit:
Q1  12  2P1  P2
Q2  12  2P2  P1
1  PQ
 20 12P1  2P12  20
1 1
Firm 1’s profit maximizing price:
Firm 1’s reaction curve:
Firm 2’s reaction curve:
1 / P1  12  4P1  P2  0
P1  3  1 P2
4
P2  3  1 P1
4
NASH EQUILIBRIUM IN PRICES
Here two firms sell a differentiated
product, and each firm’s demand
depends both on its own P and on its
competitor’s P. The two firms choose
their Ps at the same time, each
taking its competitor’s P as given.
Firm 1’s reaction curve gives its
profit-maximizing P as a function of
the P that Firm 2 sets, and similarly
for Firm 2.
The Nash equilibrium is at the
intersection of the two reaction
curves: When each firm charges a P
of $4, it is doing the best it can given
its competitor’s P and has no
incentive to change P.
The firms have the same costs, so they will
charge the same price P. Total profit is given by
: πT = π1 + π2 = 24P – 4P2 + 2P2 − 40 = 24P −
2P2 − 40.
This is maximized when πT/ P = 0. πT/ P =
24 − 4P, so the joint profit-maximizing P is
Also shown is the collusive
P = $6. Each firm’s profit is therefore
equilibrium: If the firms cooperatively
π1 = π2 = 12P − P2 - 20 = 72 − 36 − 20 = $16
set price, they will choose $6.
Competition versus Collusion
In our example, there are two firms, each of which has fixed costs of $20
and zero variable costs. They face the same demand curves:
Firm 1’s demand:
Q1  12  2P1  P2
Firm 2’s demand:
Q2  12  2P2  P1
We found that in Nash equilibrium each firm will charge a price of $4 and earn a
profit of $12, whereas if the firms collude, they will charge a price of $6 and earn
 2  P2Q2  20  (4)[(12  (2)(4)  6]  20  $20
a profit of $16.
1  PQ
 20  (6)[12  (2)(6)  4]  20  $4
1 1
So if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase
to $20. And it will do so at the expense of Firm 1’s profit, which will fall to $4.
Equilibrium
Equilibrium occurs when all
simultaneously
choose
their
response to each others' actions.
firms
best
Graphically, this amounts to the point
where the best response functions cross.
Equilibrium
Profits are positive in equilibrium since both prices
are above marginal cost!
Even if we have no capacity constraints, and
constant marginal cost, a firm cannot capture all
demand by cutting price.
Cournot, Bertrand, and Monopoly Equilibriums
A perfectly collusive industry takes into account that an
increase in output by one firm depresses the profits of the
other firm(s) in the industry.
A Cournot competitor takes into account the effect of the
increase in output on its own profits only.
Therefore, Cournot competitors "overproduce" relative to
the collusive (monopoly) point.
Further, this problem gets "worse" as the number of
competitors grows because the market share of each
individual firm falls, increasing the difference between the
private gain from increasing production and the profit
destruction effect on rivals.
Therefore, the more concentrated the industry in the
Cournot case, the higher the price-cost margin.
Cournot, Bertrand, and Monopoly Equilibriums
Homogeneous product Bertrand resulted in zero profits,
whereas the Cournot case resulted in positive profits. Why?
The best response functions in the Cournot model slope
downward. In other words, the more aggressive a rival (in
terms of output), the more passive the Cournot firm's
response.
The best response functions in the Bertrand model slope
upward. In other words, the more aggressive a rival (in
terms of price) the more aggressive the Bertrand firm's
response.
Cournot, Bertrand, and Monopoly Equilibriums
Cournot: Suppose firm j raises its output…the price
at which firm i can sell output falls.
This means that the incentive to increase output
falls as the output of the competitor rises.
Bertrand: Suppose firm j raises price the price at
which firm i can sell output rises.
As long as firm's price is less than firm's, the
incentive to increase price will depend on the
(market) marginal revenue.
Kinked Demand Curve Model
• Proposed by Paul Sweezy
• If an oligopolist raises price, other firms will not
follow, so demand will be elastic
• If an oligopolist lowers price, other firms will
follow, so demand will be inelastic
• Implication is that demand curve will be kinked,
MR will have a discontinuity, and oligopolists will
not change price when marginal cost changes
Kinked Demand Curve Model
•A model of oligopoly in which the demand curve
facing each individual firm has a “kink” in it.
• The kink results from the assumption that
• 1) competitor firms will follow if a single firm
cuts price
• 2) but will not follow if a single firm raises
price.
• This model assumes that the elasticity of
demand in response to an increase in
price is different from the elasticity of
demand in response to a price cut.
Sweezy’s kinked demand curve
model of oligopoly
Assumptions:
1. If a firm raises prices, other firms won’t follow and
the firm loses a lot of business.
So demand is very responsive or elastic to price
increases.
2. If a firm lowers prices, other firms follow and the
firm doesn’t gain much business.
So demand is fairly unresponsive or inelastic to
price decreases.
THE KINKED DEMAND CURVE
Each firm believes that if it raises
its price above the current price
P*, none of its competitors will
follow suit, so it will lose most of
its sales.
Each firm also believes that if it
lowers price, everyone will follow
suit, and its sales will increase
only to the extent that market
demand increases.
As a result, the firm’s demand
curve D is kinked at price P*, and
its marginal revenue curve MR is
discontinuous at that point.
If marginal cost increases from
MC to MC’, the firm will still
produce the same output level Q*
and charge the same price P*.
Cartels
• Collusion
– Cooperation among firms to restrict competition in
order to increase profits
• 1) Centralized Cartel
– Formal agreement among member firms to set a
monopoly price and restrict output
– Incentive to cheat
• 2) Market-Sharing Cartel
– Collusion to divide up markets