Chapter 11:
Imperfect Competition
and Strategic Behaviour
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
11.1 The Structure of the
Canadian Economy
1.
recognize that Canadian industries typically have either
a large number of small firms or a small number of large
firms.
11.2 What Is Imperfect
Competition?
2.
explain why imperfectly competitive firms have
differentiated products and often engage in non-price
competition.
11.3 Monopolistic
Competition
3.
describe the key elements of the theory of monopolistic
competition.
11.4 Oligopoly and
Game Theory
4.
understand why strategic behaviour is a key feature
of oligopoly.
11.5 Oligopoly in Practice
5.
use game theory to explain the difference between
cooperative and non-cooperative outcomes among
oligopolists.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 2
Imperfect Competition
LO1
• A market structure in which producers are
identifiable and have some control over price
• Two forms:
1. Monopolistic Competition
2. Oligopoly
11-3
© 2012 McGraw-Hill Ryerson Limited
11.1 The Structure of the Canadian Economy
Industries with Many Small Firms
The perfectly competitive model does not adequately explain many
industries that have a large number of relatively small firms.
Monopolistic competition studies the behaviour and the outcomes
in industries with many small firms, each with some market power.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 4
Industries with a Few Large Firms
Most modern industries that are dominated by large firms contain
several firms. These are not competitive markets.
The theory of oligopoly helps us understand industries with few large
firms, each with market power, that compete actively with each
other.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 5
Industrial Concentration
The concentration ratio measures economic power in an industry
and shows the market shares of the largest four or eight producers.
Defining a market with reasonable accuracy is difficult.
Sometimes the market is much smaller than the whole country.
Other times, it is much larger than the entire country.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 6
LO2
Measuring Industry Concentration
Concentration Ratio
• The percentage of an industry’s total sales that
is controlled by the largest few firms
• 4-firm concentration ratio: % of sales revenue
by 4 largest firms in industry
•
•
If < 40% may be monopolistic competition
If > 40% likely oligopoly
11-7
© 2012 McGraw-Hill Ryerson Limited
Fig. 11-1
Concentration Ratios in Selected Canadian Industries
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 8
4 Firm Concentration Ratios
Industry
LO2
1990
2005
Motor Vehicles
87.2%
100.0%
Petroleum
75.6
99.9
Tobacco
98.8
99.8
Cement
72.0
99.7
Fertilizers
56.7
99.4
Tires
86.2
99.3
Breweries
90.6
99.2
Sugar and Confectionary
47.8
98.7
Household Appliances
61.6
98.5
Coffee and Tea
76.5
97.8
Sporting and Athletic Goods
22.7
92.8
Wineries
48.5
92.2
11-9
© 2012 McGraw-Hill Ryerson Limited
Self-Test
LO2
The grummit industry consists of 10 companies.
Company
Sales $m:
A
$22
B
$6
C
$17
D
$12
E
$8
F
$15
Next 4 (total)
$12
© 2012 McGraw-Hill Ryerson Limited
a) Calculate the 4-firm
concentration ratio for
this industry.
b) What type of market does
this industry operate in?
11-10
11.2 What Is Imperfect Competition?
Firms Choose Their Products
A differentiated product: a group of products that are similar enough
to be called the same product but different enough that they can have
different prices.
Most firms in imperfectly competitive markets sell differentiated
products:
• laundry soaps, beer, cars, running shoes
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide11
Firms Choose Their Prices
Typically, firms are price setters.
Often, these prices vary only slowly over time.
Firms often let output vary in response to demand shocks to avoid
costs of changing prices (unless the shock is long-lasting).
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide12
Non-Price Competition
Imperfectly competitive firms typically engage in behaviour that
is absent in either monopoly or perfect competition:
• firms often spend large sums of money on advertising
• firms often engage in non-price competition
• firms may create entry barriers to prevent erosion
of current pure profits
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 13
Two Market Structures
The preceding discussion applies in general to imperfectly
competitive market structures.
• Industries with a large number of small firms—
the theory of monopolistic competition.
• Industries with a small number of large firms—
the theory of oligopoly (which involves game theory).
A key difference: strategic behaviour displayed by firms.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 14
11.3 Monopolistic Competition
The Assumptions of Monopolistic Competition
1. Each firm produces one variety of the differentiated product.
Thus, it faces a negatively sloped and highly elastic demand
curve.
2. All firms have access to the same technology and thus have
the same cost curves.
3. The industry contains so many firms that each one ignores
competitors when making price and output decisions.
4. Firms are free to enter and exit the industry.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 15
Empirical Relevance of Monopolistic Competition
The theory of monopolistic competition is useful for analyzing
industries with low concentration ratios and differentiated products:
• Restaurants
• Clothing
• Hair stylists
• Mechanics
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Chapter 11, Slide 16
Predictions of the Theory
Fig. 11-2(i) Profit Maximization for a Firm in Monopolistic Competition
In the short run, a monopolistically competitive firm faces a downward
sloping demand curve and maximizes profits by equating MR and MC.
In the short run it is possible for the firms to make positive profits,
break even, or even to make losses.
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Chapter 11, Slide 17
Predictions of the Theory
Fig. 11-2(ii) Profit Maximization for a Firm in Monopolistic Competition
This firm is earning positive profits.
 an incentive for new firms to enter the industry.
 the existing market demand must be shared among a larger
number of firms.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 18
Fig. 11-2(i) Profit Maximization for a Firm in Monopolistic Competition
As new firms enter, profits per firm are reduced, and eventually
eliminated.
In the LR equilibrium, each firm has excess capacity.
This result is often called the excess-capacity theorem of monopolistic
competition.
2014 Pearson Education Canada Inc.
Chapter 11, Slide 19
Predictions of the Theory
In contrast to perfect competition, the LR equilibrium in monopolistic
competition does not minimize ATC—
there is excess capacity.
This excess capacity may not be wasteful if consumers value
product variety.
Society faces a tradeoff between product variety and lower cost
per unit.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 20
11.4 Oligopoly and Game Theory
Oligopoly: an industry containing two or more firms, at least one of
which produces a significant portion of the industry's total output.
An oligopolistic firm faces only a few competitors.
 Strategic behaviour is central to their actions.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 21
Oligopoly
LO4
Characteristics
•
•
•
•
•
•
It is dominated by a few large firms.
Entry by new firms is difficult.
Nonprice competition between firms is widely
practised.
Each firm has significant control over its price.
Mutual interdependence exists between firms.
Products can be either homogeneous or
differentiated.
11-22
© 2012 McGraw-Hill Ryerson Limited
Oligopoly
LO4
Mutual interdependence
the condition in which a firm’s actions depend, in
part, on the reactions of rival firms
11-23
© 2012 McGraw-Hill Ryerson Limited
The Basic Dilemma of Oligopoly
Oligopolistic firms will make more joint profits if they cooperate,
or collude. But each individual firm may make more profits if it
"cheats."
How could firms reach a cooperative outcome to maximize their joint
profits?
Game theory is used to study decision making in such situations—
each player takes account of the others' expected reactions when
making a move.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 24
Collusion
LO5
Collusion
an agreement among suppliers to set the price of a
product or the quantities each will produce
Game Theory
a method of analyzing firm behaviour that highlights
mutual interdependence among firms
11-25
© 2012 McGraw-Hill Ryerson Limited
Some Simple Game Theory
Game theory: the theory that studies decision making in situations
in which one player anticipates the reactions of other players to its
own actions.
When game theory is applied to oligopoly:
• the players are firms.
• their game is played in the market.
• their strategies are their prices or output decisions.
• the payoffs are their profits.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 26
Consider a simplified duopoly in which two firms choose to
cooperate or compete:
Cooperate: produce 1/2 of the monopoly output
— yields low output and high price
Compete: produce 2/3 of the monopoly output
— yields high output and low price
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Chapter 11, Slide 27
The payoff matrix for this game:
Fig. 11-3
The Oligopolist's Dilemma: To Cooperate or to Compete?
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Chapter 11, Slide 28
A Nash equilibrium is an outcome in which each firm is doing
the best it can given what the other firm is doing.
Note that for each firm, the best action is to "compete,"
no matter what the other firm is doing.
So in this game, the Nash equilibrium has both firms "competing"
and producing the higher level of output.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 29
Fig. 11-3 The Oligopolist's Dilemma: To Cooperate or to Compete?
Cooperative
Equilibrium
Nash
Equilibrium
But notice that the Nash equilibrium does not maximize joint profits
—this is the classic example of the prisoners' dilemma!
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 30
The basis of a Nash equilibrium is rational decision making in the
absence of cooperation.
Once in a Nash equilibrium, no firm has an incentive to unilaterally
alter its own behaviour.
EXTENSIONS IN HISTORY 11-1
The Prisoners' Dilemma
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Chapter 11, Slide 31
Self-Test
LO5
Suppose that Spartan Inc. and Trojan Ltd, the only two firms
in the industry, have entered into a collusive agreement
to share the industry’s total profits of $50 million equally.
However, if any one of them cheats, it will increase its
profits by $10 million at a cost of $10 million to the other
firm. If they both cheat, they will each reduce their profits
by $5 million.
a) Construct a matrix showing the various options.
b) Which option will they likely chose?
© 2012 McGraw-Hill Ryerson Limited
11-32
Extensions in Game Theory
The simple game described applies to oligopolists producing identical
products.
Game theory can be used in other settings:
• how firms interact when they charge different prices
for their differentiated products.
• how firms interact when the decision is whether
to develop a new product.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 33
11.5 Oligopoly in Practice
The simple game described applies to oligopolists producing
identical products.
Types of Cooperative Behaviour
When firms agree to cooperate in order to restrict output and
raise prices, their behaviour is called collusion.
• explicit collusion occurs when firms formally agree—DeBeers
and OPEC
• cooperation without explicit agreement is called
tacit collusion.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 34
LESSONS FROM HISTORY 11-1
Explicit Cooperation in OPEC
Types of Competitive Behaviour
• firms may compete for market share
• firms may offer secret discounts to increase sales
• firms may use innovation and attempt to gain
advantage over rivals in the very long run
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Chapter 11, Slide 35
The Importance of Entry Barriers
In the absence of natural entry barriers, oligopolistic firms must
create entry barriers if they are to earn profits in the long run.
Brand Proliferation as an Entry Barrier
A large number of differentiated products leaves small market share
available to a new firm.
This is one explanation for many varieties of a product being
produced by the same firm.
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Chapter 11, Slide 36
Advertising as a Barrier to Entry
Heavy advertising can force an "outside" firm to spend heavily
on its own advertising.
If the "outside" firm had a low MES, the new advertising costs
may result in a much higher MES  deters entry.
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Chapter 11, Slide 37
Predatory Pricing
A firm will not enter a market if it expects continued losses
after entry.
Existing firms can create such an expectation by keeping prices below
their own costs until the entrant goes bankrupt.
The existing firm loses profits, but it also discourages potential
future rivals.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 38
Oligopoly and the Economy
Temporary changes in demand lead to more price volatility in
competitive markets than in oligopoly markets.
Permanent changes in demand, however, lead to similar adjustments
in both market structures.
Oligopoly is an important market structure in modern economies
because there are many industries in which the MES is simply too
large to support many competing firms.
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Chapter 11, Slide 39
Oligopolists often grow through mergers or by driving rivals
into bankruptcy.
This process increases the size and market share of survivors,
and possibly reduces the extent of competition in the market.
The challenge for public policy is to keep oligopolies competing
and using their competitive energies to improve products and
reduce costs.
Copyright © 2014 Pearson Canada Inc.
Chapter 11, Slide 40