C H AP T E R
TH I R T E EN
C o n s t r u c t i n g a m o d e l o f
c o m p e t i t i o n
i m p e r f e c t
Model of Imperfect Competition
Suppose you were contacted by a businessman who was interested in growing
corn and he hired you to assess the probability of his success. How would you do this?
Well first of all we would need to know something about the anticipated costs of
production. From all our previous exposure to costs we have learned that their respective
curves will look as follows:
MC
ATC
AVC
P
Q
Now that you have drawn the above graph for your client are you able to
unequivocally assure him that his business venture will be profitable? No, we cannot
come to that conclusion just yet, because we have not determined the market clearing
price of corn. Therefore, before we meet with our client we survey the market.
From our market survey we learn that due to current weather conditions that a
bumper crop of corn is expected this year. In fact, in lieu of these expectations the
futures market has predicted that corn prices will fall.
Futures market = A market in which contracts for the future delivery of
commodities are bought and sold. The contracts themselves are called futures. The
contract represents an agreement to deliver or to receive some commodity at a specified
price at some future time.
Based on this what do we conclude? Well, actually two solutions are possible.
First of all you could write a report that is based on every conceivable business situation
that could prevail. This would obviously take a lot of time and your deadline for
submission is near. Secondly we could create a market condition that could exist under
certain situations and estimate your probability of success given these constraints. If we
did create such a model of the market what condition would we present?
Obviously we are looking at a perfectly competitive market. We know this must
be so because corn is a homogeneous product. We are taking the market price for our
product because, there is a large number of buyers and sellers, freedom of entry and exit
from this market exists, and, all participants within the market have perfect knowledge.
Now applying our vast economic expertise to all this information the following
model of our client’s position:
In preparation for your meeting with your client you try to anticipate all the
questions he may have. Such as:
1. Is he making a profit?
2. How many bushels of corn should he produce to maximize profit.
3. Why the demand curve for his product is perfectly horizontal.
Finally, after several days of practicing your presentation the day of the formal
performance arrives. There you sit, armed with all your data, market surveys, charts and
graphs, just reeking with confidence and the knowledge that you are prepared for
anything. Finally you will meet, for the first time, the owner of the firm.
In he walks, a peculiar looking chap who for some reason looks familiar. The
moment he is introduced as Orville Redenbacher you know you have made a crucial
mistake. You see the model we have created assumes that price is the only concern of the
buyer. Is it? Some consumers may be equally concerned with the quality of the products
they consume. If this is true we cannot assume that all products are homogeneous. Just
by changing that one condition invalidates the model we have created.
Suppose ole Orville seriously thinks that his corn is of a higher quality than all
others. In fact suppose that he is able to convince consumers that his corn is gourmet
corn. Does he have to compete against all the other corn growers? No! By establishing
that a difference exists between his corn and other corn he has differentiated his product
from all others. This corn is one of a kind. How does this change the model?
Well for one thing he doesn’t have to be a price taker any longer. In this case
Orville can be a price searcher, that is, he can manipulate his price until he discovers a
price at which his profits are maximized. Changing prices will certainly affect the
quantity demanded. At least that’s what the law of demand claims. If this is true, what
does Orville’s demand curve look like? Since Orville has differentiated his product, the
demand curve for his firm will be downward sloping and relatively elastic.
In this case the curve is relatively elastic because there are many other substitute
goods available. Unlike the case of monopoly, where only one firm represents the entire
industry, in monopolistic competition there are many small firms competing for sales.
From the sequence of events just described it is easy to see why producers are
eager to control their products. Economic profit can result.
This is what we call monopolistic competition. The characteristics are:
1. large number of independent buyers and sellers;
2. product differentiation exists;
3. the firms are small relative to the size of the market;
4. low barriers to entry exist.
Because their very existence depends on distinguishing themselves from their
competitors product differentiation becomes the foundation of this model.
Differentiation exists due to:
1. better service
2. more accessible
3. greater variety of brands
4. special sales - discount stores
5. advertising
Providing better service is one way to distinguish your enterprise from that of
your competitors. If you look at many of our retail stores you will notice they all seem to
stock the same items. computer stores for instance all carry the same brand names so
they can attract the same customers. Where they may differ is by the service they offer
their customers. some stores only offer the manufacturers warranty while others will
provide extended warrantees and “in home” service.
Accessibility can refer to the geographical location of the business or the location
of your product within a retail store. For example an automobile dealership located on
the back streets of a small town will attract much less business than a dealership located
on or near a major thoroughfare in a larger metropolitan area. This can be attributed to
both the increased visibility of the business as potential customers pass the lot each day
and their ability to easily get there.
Variety of goods within a store may also attract more consumers. Computer
stores, for example, first tried to offer exclusive products. Some stores were dedicated to
only IBM products while others were exclusively Apple products. Offering an exclusive
product may be an attraction when the product is new, but eventually firms realize the
importance of broadening their customer base by offering greater variety.
Today many stores have realized the price sensitivity of the consumer and have
differentiated themselves from traditional retailers by continually offering sales or
discounted prices. K-Marts, Price Clubs, and Sam’s Club now dot our landscape and
offer consumers an alternative way to purchase goods.
However, the most frequently used method used to differentiate our firm from all
others is through advertising. Firms use anything from simple sales flyers to very
sophisticated advertising campaigns to make consumers aware of them and their
products.
ADVERTISING EXPENDITURES IN THE U.S.,
1776-1990 (Millions of dollars)
Year
1776
1800
1820
1830
1840
1850
1860
1870
1880
1890
1900
1910
1920
1930
1940
Amount
$ 0.20
1.00
3.00
7.00
12.00
22.00
40.00
150.00
175.00
300.00
450.00
1,000.00
1,100.00
2,110.00
2,840.00
Year
1950
1960
1965
1970
1975
1980
1985
1988
1990
Amount
5,700.00
11,960.00
15,250.00
19,550.00
28,160.00
54,780.00
94,750.00
118,050.00
132,640.00
U.S. ADVERTISING EXPENDITURES BY MEDIA,
1987-88 (millions of dollars)
Medium
Newspapers
National
Local
Magazines
Television
Network
Cable
1988
expenditures
$31,197.00
3,586.00
27,611.00
6,072.00
25,686.00
9,172.00
942.00
Percent
of total
26.4%
3.0
23.4
5.1
21.8
7.8
0.8
Syndication
901.00
0.8
Local
7,270.00
6.2
Radio
7,798.00
6.6
Direct Mail
21,115.00
17.9
Yellow Pages
7,781.00
6.6
Source: McCann Erickson Inc. Newspaper Advertising Bureau (1989)
TOP 10 NATIONAL ADVERTISERS,
1988 (millions of dollars)
Rank/Company
Total spending
1. Phillip Moris
$2,058.2
2. Procter & Gamble
1,506.9
3. General Motors Corp.
1,294.0
4. Sears
1,045.2
5. RJR Nabisco
814.5
6. Grand Metropolitan
773.9
7. Eastman Kodak Co.
735.9
8. McDonald’s Corp.
728.3
9. Pepsi Co. Inc.
712.3
10. Kellogg Co.
683.1
Source: McCann Erickson Inc. Newspaper Advertising Bureau (1989)
Under monopolistic competition we can charge higher prices because:
1. Quality differences exist - these differences can be real or imagined, and are
sometimes created through our advertising.
2. Price discrimination - monopolistic competitors frequently engage in price
discrimination because they are aware of the consumers’ multiple demand elasticities and
how to segment the market.
Multiple demand elasticities are due to differences in income-as income rises
price sensitivity falls for basic necessities. Also geographic locations within the nation
may differ in their pay scales. In addition, firms tend to locate where incomes are higher
increasing the number of alternatives and thus making the the price elasticity of demand
greater. Firms also recognize that individual tastes play a major part in determining our
willingness to consume certain goods.
Firms in monopolistic markets also engage in market segmentation. Since
families tend to reside in communities with families of similar income level.
Communities can then be identified by household income and firms can target products
for specific income levels.
Firms may also segment the market based on quantity of purchase-discounts for
consumption of high volumes of goods can be offered by firms since such sales lower
handling costs.
Perhaps the easiest way to segment a market is by geographic location-groups of
consumers that are physically separated by great distances, mountain ranges or bodies of
water may find themselves paying different prices for similar goods since their ability to
find suitable substitute sources of these goods is limited.
Within retail stores an internal form of segmentation called location can be
practiced. This refers to location of goods within a store. Studies have shown that goods
placed at eye level (for the average consumer) have a greater probability of being
consumed than other goods.
Using the model for monopolistic competition we should note that firms in this
market structure operate much the same as perfect competitors. That is to say that they
will also subscribe to the profit maximizing rule and produce at the point where
MR=MC. If economic profits result, then due to the low barriers to entry, they can
anticipate more competitors entering the industry. This entry will force prices downward
eventually stabilizing at the point of normal profit.
Normal
Profit
MC
ATC
P
AVC
D
MR
Q
We have thus far observed that a certain portion of our market is characterized as
competitive, monopolistically competitive and monopolies. However, we also know that
some firms that exist today do not fall into any of the above categories. There are
industries in which only a few sellers operate. This is market structure is known as
oligopoly.
Characteristics of this market structure are:
1. large scale production is necessary to attain a low per unit cost.
2. recognized interdependence exists between firms in oligopolistic industries.
3. substantial barriers to entry exist.
4. produce either a homogeneous of differentiated product.
This model actually takes into consideration both the actions and needs of each
firm in the industry and the industry itself. If left to their own devices each firm in an
industry would be forced to compete with other firms. This competition means that
millions of dollars have to be spent in advertising campaigns. That is millions of dollars
that could be used for other purposes if the competition was not so intense.
One way to lower this cost is to get your fellow producers to agree to one set price
for the industry. If that price is high enough maybe everyone could realize above average
rates of return.
Getting producers to agree to maintain one set price is what we economists call
collusion.
Collusion is an agreement among firms to avoid various competitive practices,
particularly price reductions. When firms join together to control prices and output we
call the group a cartel.
Collusion is most likely when: Few sellers are present in the industry or a
homogeneous product is being produced. The fewer the number of oligopolists the easier
it is to agree on the actions required to keep prices high. It is also easier to monitor each
other when the cartel consists of few members.
There at least five contributing factors that make collusion least likely: the
number of oligopolists is fairly large; secret price cuts are difficult to detect; barriers to
entry are low; market demand conditions are unstable; and anti-trust action is vigorous.
If we are talking about an industry in which only a few sellers operate then we are
talking about an oligopoly. The characteristics of this industry are:
Large scale
production is necessary to attain a low per unit cost. Automobile are a good example of
this. Automotive experts has estimated that to build a basic car from the ground up by
collecting all your own material and machining the parts would cost in excess of $50,000.
Mass production of automobiles has provided firms the ability to realized economies of
scale which lower production costs.
A recognized interdependence exists between firms. This characteristic simply
means that producers in oligopolistic industries must watch each other carefully because
of the limited number of producers. If firms in the industry did not respond to favorable
changes, either to the product or in the production process, then one firm could attract
more consumers to his product. Industries with high operating costs cannot afford to lose
a large portion of their customer base.
A third characteristic is that substantial barriers to entry exist. The substantial
barriers are the high start up costs. Before any new producer can enter the automotive
industry, for example, he will need to invest in buildings and machinery to produce on
the same scale as the existing competition. This initial cost represents a significant
barrier to entry.
Oligopolists produce either a homogeneous or differentiated product. This model
is like a hybrid of all the others we have examined in this regard. The oil industry is a
good example of an oligopolistic industry where a homogeneous product is being
produced.
Notice that in the model for the firm that the demand curve is relatively more
elastic than the demand curve for the industry. Firms in this market structure may be few
in number, but nevertheless they do represent potential competition. Therefore,
individual firms will be price sensitive and this is implied with a relatively elastic demand
curve.
Now the demand curve for the industry assumes that some collusion has occurred.
As we group together we eliminate some of the competition from the industry.
Accordingly, the demand curve becomes less elastic. With less competition we can
charge higher prices and earn higher profits.
Although there is a strong incentive to collude there is also reason to cheat on
your agreements. Each oligopolist realizes that their individual demand curve must be
more elastic than the industry demand curve. Therefore, if they were to decrease price
below the agreed price they could expect quantity demanded to increase and also their
profits. However, if one firm decreases prices the other oligopolists in the industry will
also, and so no one firm will increase its share of the market. Conversely, if we increase
price we know that our competitors will not follow our lead and, therefore, we will lose a
portion of the market. Given these observations we can note the following:
1. the demand curve is elastic above the set price.
2. the demand curve is inelastic below the set price.
3. therefore oligopolists tend to be price rigid.
4. hence we know that a kinked demand curve exists.
On the first graph: Df= the demand curve for the firm. Di= the demand curve for
the industry. MRf= the marginal revenue curve for the firm. MRi= the marginal revenue
for the industry. In this first graph we are demonstrating the incentives that exist for
cheating on collusive agreements. According to our agreement the industry will produce
q5 levels of output and charge price p7. However, by looking at my relatively more
elastic demand curve I realize that by lowering the price just a little I can increase the
quantity demanded and therefore earn higher profits. Higher profits can be a great
incentive!
The second graph (above) indicates that if I do cheat on our agreement I should
expect some retaliation. The essential idea of the kinked demand curve is that the
oligopolist’s will maintain their prices when other firm’s raise theirs, thus the demand
curve will be very elastic for a price increase; but, very inelastic for a price decrease
because other firms will respond by also reducing their prices. This all implies that prices
in oligopolistic industries are quite stable because we are watching each other so closely.
Given the model of oligopolistic industries many economists predicted that the
Organization of Petroleum Exporting Countries (OPEC Cartel) would fail soon after its
creation. Although that prediction was not realized OPEC did eventually circum to the
logic of the model. The following graphic demonstrates changes in their output and
pricing levels over a 22 year period.