the world of imperfect competition

The World of Imperfect Competition

Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off.

-Franklin D. Roosevelt

Slide 1 of 49

In this module, we conclude our study of firm behavior…

Slide 2 of 302

We now turn our attention to an environment between perfect competition and monopoly…called ‘imperfect

competition’.

In this module, we’ll explore how monopolistically competitive firms and oligopolies behave, how they

make decisions, and how they compete.

It covers a key learning outcome and if you continue to study economics, you will see it all again.

Let’s turn our attention to Monopolistically competitive firms

Perfect Competition Monopolistic Competition Oligopoly Duopoly Monopoly

This was the topic of Modules 8

and 9

This was the topic of Module 10

Market Structure Overview

Slide 3 of 49

Let’s review these market structures


Most firms are monopolistically competitive

Characteristics of monopolistic competition:

There are a relatively large number of sellers

There are a lot, but not thousands of competitors.

Examples might include grocery stores.

Producers do face a competitors

Widespread non-price competition exists

There are minimal barriers to entry

Imperfect competition includes all things between Perfect competition and monopoly.


This means that sellers are in heavy competition and have to

keep prices low.

Examples include gas stations.

Since it is difficult to compete on price, producers differentiate their products to prove they are better.

Examples include fast food chains.

You can open a hamburger or hot dog stand and compete with big

fast food chains.

Examples include a downtown food truck or neighborhood food

vendor.

Slide 4 of 49

Types of market structures


In this category, there are only two or a few producers. Firms here are less numerous, but big.

Characteristics of oligopolies and duopolies:

Market has only a few or two sellers

Examples include big box superstores.Each firm is affected by decisions of others

Barriers to entry exist

Firms are always ‘looking over their shoulder’ for changes in

competitor’s behavior.

Examples include the airlines.

Barriers to entry are not insurmountable, but they are

daunting.

Examples include tobacco companies.

“Du” means two. “Oli” means several. We’ll treat these as one group.


Slide 5 of 49

Review: Examples offirms in different markets


NB

A, M

LB, N

HL, N

FL

Coke and P

epsi

IBM

in the 1980s

Banks

Coffee S

hops

Soap M

anufacturers

Tomato F

armer

Hoover D

am

DeB

eers Diam

onds

TV

Netw

orks in the 1960s

Airlines

Grocery S

tores

Hotels

Catfish F

armer

Wheat F

armer

Aircraft M

anufacturers

Greeting card com

panies

Cigarette m

akers

Cereal M

anufacturers

Operating S

ystem producers


Slide 6 of 49

Monopolistic competition

A large number of firms but not so many that each firm’s output is insignificant

Monopolistic Competition

Slide 7 of 49

Monopolistically competitive firms have unique characteristics

• There are a relatively large number of sellers (i.e. dozens or more, but not thousands)

• Producers face a lot of competition

• There are minimal barriers to entry

• Producers have limited control over price

• Instead producers practice widespread “non-price competition”

These characteristics will be described a little later.

The next slide will provide an example for these.


Slide 8 of 49

Lodging is a monopolistically competitive industry

There are a large number of sellers

A good example is the hotel industry. There are probably hundreds of hotel brands, big and small.

Producers face a lot of competition

Pull off any exit in an urban area and see how many hotel signs you see.

There are minimal barriers to entry

Get a business license, a building, and a sign out front and you can compete!

Monopolistically Competitive

Characteristic Comment


Sean’s B&B

Slide 9 of 49

So do monopolistically competitive firms have control over their price?

With product differentiation… yes….a little.

For example, are their prices the same?


Slide 10 of 49

So do monopolistically competitive firms have control over their price?


Monopolistically competitive firms are not price takers like perfectly competitive firms.

But their prices typically don’t differ by much

Gas$3.79 /gal

Gas$3.81 /gal

Slide 11 of 49

So instead of competing on price, they compete on product characteristics

Monopolistically competitive firms engage in heavy “non

price competition”.

That means they try to convince you (mainly through advertising) that their product

is different (or more specifically, better!)

This is called “Product Differentiation”.

Safety Ratings

Here are some examples of product differentiation.

These firms have advertised heavily to differentiate their product. Can you match them?


Maytag

Have it your way!

Safety!

Slide 12 of 49

Product differentiation is a key aspect of this market

structure.

For your business proposal, you’ll probably have to show how you plan to differentiate

your goods and services!

How can numerous firms differentiate relatively similar products

• Emphasize product attributes – Physical or qualitative differences are emphasized

• Emphasize superior service– Firms set themselves apart by providing good service

• Provide the best location– Being closer to a customer offers a competitive edge

• Incorporate brand name and packaging

– A name you know or trust

– An association with a person

These are all elements of “Non Price

Competition”


Gas$3.81 /gal

Slide 13 of 49

http://www.harristeeter.com/default.aspx





Individual exercise

Take 5 minutes and think of three firms that advertise heavily as they try to differentiate their product


This shouldn’t be hard unless you don’t watch TV, don’t read magazines, and don’t listen to

the radio!Slide 14 of 49

Key Characteristics of Monopolistic Competition


Let’s discuss this characteristic next.

Slide 15 of 49

The monopolistically competitive firm's demand curve is highly elastic


We saw that a perfectly competitive firm faces a

perfectly elastic demand curve.

We saw that a Monopolist faces

the industry demand curve.

A monopolistically competitive firm

faces a highly elastic demand curve.

Note that the slope of this demand curve falls somewhere between that faced by a perfectly competitive firm and that

faced by a monopolist!

Slide 16 of 49

Why the highly elastic demand curve?

Monopolistically competitive firms face a highly elastic

demand curve because they face a lot of competition.

Notice how a slight increase in price causes large declines

in quantity demanded.

With a lot of competition, that is what these firms see. If

they raise price, customers go to their competitors!


Slide 17 of 49

How do monopolistically competitive firms maximize profit?

Again, continue to expand production as long as MR>MC then stop when MR=MC


With no units produced, profit will be -$55, which are the fixed costs.

With one unit produced, profit will be -$8, but MR>MC so expand

production.

With two units produced, profit will be $38, but MR>MC so expand

production.

With 7 units produced, profit will be $182, and MR=MC. This firm should

stop there.

With output above 7 units, MC>MR. This firm should not produce these units - they cost more to make than

they bring in!

Slide 18 of 49

Profit maximization, seen graphically


Profit maximization is found where MR=MC. But what price will this firm charge?

Like monopolists, price will be as high as the market will bear. Follow the MR=MC point up to the demand

curve

Remember though, just like in perfect competition, these economic profits are going to lure new suppliers in. With little barriers to entry, what is stopping them?

Slide 19 of 49

Here we see a decision based on marginal benefit (revenue) – marginal cost analysis for an imperfectly competitive firm. In this case is it for a monopolistically

competitive firm. That is a key learning outcome!

Losses, shown graphically

And, just like in perfect competition, these economic losses will drive away current

suppliers.


Slide 20 of 49

Eventually, though, only normal profits are earned

So, economic profits will draw competitors. With low barriers to entry, there is little stopping them.

As competitors join, demand (and MR) curves shift downward and profit shrinks.

Why? Because with more firms, each firm has a smaller share of the market.

Eventually, the demand curve becomes tangential to the ATC and all economic

profits are gone.


Slide 21 of 49

Note a distinction

$5.00

100 units

Note that as other firms enter, profit maximizing output for a monopolistic

competitor eventually reaches a point that is not at the lowest point of the ATC curve.

Unlike perfect competition, society does not benefit from the guarantee that this

product will be produced at its lowest cost.

If monopolistic competitors were to minimize price,

they would operate here (at the low point of the ATC) and fewer firms could meet all

demand (Because each firm would have a higher

output).

Instead, the industry is

overcrowded with firms operating at below capacity.

Industry example: How many times have you been to a hotel where there were vacant rooms on your hall?


$4.75

200 units

Industry example: And how many times do you see a hotel commercial on TV as they try to product differentiate?

Slide 22 of 49

Eventually, economic profits disappear

This process can be slowed by the monopolistically competitive firm so they can enjoy economic profits as long as possible

Product differentiating and advertising!Monopolistically competitive firms want to slow this process down to hang on to economic profits, but how can they?!?


Slide 23 of 49

Comparison

• In perfect competition there is a constant drive to reduce prices to maintain competitiveness

• In monopolistic competition, there is a constant drive to maintain economic profits

“Anybody can cut prices, but it takes brains to produce a better article.”

–P.D. Armour


Slide 24 of 49

Oligopolies and duopolies

A few firms, each of which has significant market power

“Oli” is Greek for “Few”Slide 25 of 49

Oligopolies &Duopolies

Oligopolies and duopolies


Let’s turn our attention from Monopolistic Competition to Oligopolies and Duopolies


Slide 26 of 49

In an oligopoly, there could be several firms…perhaps 5.

In a duopoly, there are only two.

Generally, these behave similarly so we will treat them as one group.

Review: Types of markets


• Product is homogeneous

• There are many buyers and sellers

• Firms constitute a very small fraction of the market

• Firms have no control over price

• No barrier to entry

• Examples: Poured Concrete Contractors (27,149); truck transportation (112,642)

• Single firm that produces the entire supply of a product

• Producer does not face a competitor(s)

• Substantial barriers to entry

• Product does not have a substitute (i.e. it is heterogeneous)

• Examples: Microsoft, Cox Communication

• Market has only a few or two sellers

• Each firm is affected by decisions of others

• Barriers to entry exist

• Examples: RJR Reynolds, Wal-Mart

• Relatively large number of sellers• Producers do face a competitors• Widespread non-price competition where

producers try to differentiate their products by brand

• Minimal or no barriers to entry • Examples: Starbucks, McDonalds


Slide 27 of 49

Review: Examples offirms in different markets


NB

A, M

LB, N

HL, N

FL

Coke and P

epsi

IBM

in the 1980s

Banks

Coffee S

hops

Soap M

anufacturers

Tomato F

armer

Hoover D

am

DeB

eers Diam

onds

TV

Netw

orks in the 1960s

Airlines

Grocery S

tores

Hotels

Catfish F

armer

Wheat F

armer

Aircraft M

anufacturers

Greeting card com

panies

Cigarette m

akers

Cereal M

anufacturers

Operating S

ystem producers


Slide 28 of 49

Oligopolies and duopolies also have unique characteristics

• The market has only a few or perhaps two producers

• Producers are significantly affected by other firm’s decisions

• There are substantial barriers to entry

• Producers face a ‘kinked’ demand curve This characteristic will be

described a little later.

The next slide will provide an example for these.

Note: Du is Greek for two and oli is Greek for several


Slide 29 of 49

The hotel industry is an example of a monopolistically competitive market

A few large firms dominate the industry

An overwhelming portion of the industry’s output is produced by only a few firms. Many soft drinks are produced by either Coke or Pepsi

Producers are significantly affected by decisions of others

Imagine what airfare prices out of Norfolk (ORF) would do if Southwest stop providing service.

There are substantial barriers to entry

Generally speaking, how have the mom and pop hardware stores done against the big box stores? Not too well.

Oligopolistic or Duopolistic

Characteristic Comment


Hardware

Slide 30 of 49

Oligopolists and duopolists have a unique relationship with competitors

• Like a monopolist, an oligopolist (or duopolist) has significant pricing power. They are “price makers”

• Unlike monopolists, they must consider what their rivals are doing with regard to the price.

Pricing and output decisions must include a strategic

component


Slide 31 of 49

An example of mutual dependence: Game theory

Analyze the following table.

Assume your company’s costs will be $60 million in this year.

Select a pricing strategy for your company given the information below. Do you set prices high or low?


Slide 32 of 49

An example of mutual dependence: Game theory (part II)

I suspect you chose a low price. You can’t risk only earning $40 million (i.e. losing $20 million) if you pick a high price and your competitor picks a low price.

Neither can your competitor, so you both wind up pricing your product low.

This is a good example of mutual dependence in pricing decisions.


Slide 33 of 49

Collusion: the great temptation for oligopolists

If you and your competitor had a meeting and both agreed to set prices high, then you could operate here and

make more money.

That is called “collusion” and it

is illegal!


Slide 34 of 49

Oligopolists and duopolists facea kinked demand curve

Mutual dependence also causes the oligopolist and duopolist’s

demand curve to take a unique shape.

We call in “kinked” because it has a bend in it.

The next few slides will explore this idea.

What is my competitor

going to do?


Slide 35 of 49

Cheating

First some assumptions

Assume you are a business owner in an industry with three firms- yours

and two others.

Assume you are all charging $90 for the one good that you all produce.

Assume you are considering increasing the price by $10

$90

+$10

Assume you do not collude with your competitors


Slide 36 of 49

What if firms don’t match your price increase?

If your rivals do not match all your price changes then you face a more elastic

demand curve

1,000

$90

1,500

In this case, a $10 increase in price, which is unmatched by

your rivals, causes a large drop in the quantity demanded of your good as consumers switch to the

cheaper good!

$100$90


Slide 37 of 49

What if firms do match your price increase?

$100$90

1,4

00

1,5

00

If your rivals do match your price changes, then you face a more

inelastic demand curve

If your rivals do match your price

changes, then the same increase in

price does not cause a similar

decline in quantity demanded.

Since all three competitors have increased price by

$10, customers cannot switch to

another producer’s product to save

money.


Slide 38 of 49

So, will your oligopolistic competitors match your price change or not?

$90

It depends on the direction of the price change!

For price reductions, rivals will likely match price

changes for fear that they will lose customers to a

rival’s lower price!

Do not Match

Do Match


Slide 39 of 49

So, will your oligopolistic competitors match your price change or not?

$90

For price increases, rivals will likely not match price changes in order to steal new customers from you!

Do not Match

Do Match


Slide 40 of 49

Therefore, oligoplists operate with a “kinked” demand curve

Oligopolists face this portion of the demand

curve where price changes are not

matched

Oligopolists face this portion of the demand

curve where price changes are matched

Therefore, this is the oligopolist’s demand curve

Notice the bend or “kink” in the demand

curve


Slide 41 of 49

So what does that mean for the oligopolists’ marginal revenue curve?

Recall that there were two MR curves for the different scenarios

Similar to demand, the oligopolist faces portions of

each MR curve

$90

Where price increases are not matched, an oligopolist faces portions

of MR1

Where price increases are matched, an oligopolist

faces portions of MR2

The Oligopolist’s MR curve


Slide 42 of 49

Price stability is typical in industries dominated by oligopolists


Because of oligopolistic behavior (i.e. firms typically match price cuts but not price increases),

prices are generally not changed often.

Firms are busy constantly watching each other!

Slide 43 of 49

Real world case study: Airlines

Between 1995 and 2006, consumer

prices increased by

more than 30%.

During the same period,

airfares increased by about 10%. Airlines were

scared to change prices.

If they raised prices, they lose customers. If they lowered prices

they could start a “price war”.


Slide 44 of 49

Here is a typical story highlighting oligopolist behavior

U.S. airlines raise fares in domestic markets

Fri Nov 3, 2006

• NEW YORK (Reuters) - Several major U.S. airlines have raised fares in some markets by $5 each way, after two unsuccessful efforts to hike prices in recent weeks.

• American, Continental, United, Northwest and Delta Airlines each said on Friday that they raised fares in domestic markets not served by low-cost carriers.

• If the price increase holds, it would mark the first broad fare increase since August when tighter security measures were implemented.

• Attempts at broad-based fare increases have failed in recent weeks, with companies rescinding hikes twice in targeted markets after low-cost carriers and some traditional airlines did not match the increases.

• But unlike recent attempts to increase fares, the latest effort, which affects more markets, is expected to hold because it is not dependent on low-cost carriers playing along.

We are lucky to be served by a low cost carrier! It keeps prices of

all carriers lower!


Slide 45 of 49

In some cases, oligopolists collude

If firms (secretly) agree to match prices (i.e. collude) they can operate on this portion of

the demand curve

$100

1,000

$120

900300

If firms collude and agree to match price increases, then a $20 increase here causes a loss of only 100

customers instead of 700!


Slide 46 of 49

So why don’t firms collude?

Obstacle Comment

Number of firms It is harder for 5 firms to collude than it is for 3 firms.

Cheating A colluding firm may agree to a price increase then cheat, lower prices and capture customers.

Firm entry Keeping prices high invites new firms to enter into competition.

It is ILLEGAL!That doesn’t stop people though!


Cheating

+$10

Slide 47 of 49

What happens if you collude and get caught?

Four Wisconsin road construction executives were arrested in 2004 on bid rigging and wire fraud charges for participating in a conspiracy involving projects let by Wisconsin’s Department of Transportation

The projects, which included public road, highway, bridge, street and airport construction, were worth more than $100 million to the state.

The Justice Department alleged that in telephone calls and in-person meetings, the executives shared bid information, discussed potential competitors and agreed to rig bids in an attempt to allocate projects among themselves.

In the end, they pled guilty. $30 million in fines were appropriated3 were jailed1 was given house arrestAll were forbidden to bid on state or federal projects forever


Slide 48 of 49

A summary of characteristics of different market structures

We have now outlined all our market structure characteristics. Be sure you know these. Many questions

on the next test could come directly from this table.Slide 49 of 49

Credits

Slide 8 - http://www.flickr.com/photos/mpd01605/3940236658/Slide 9 - http://www.flickr.com/photos/10542402@N06/7334081170/ and http://commons.wikimedia.org/wiki/File:Food_Lion_University_Dr_Durham,_NC.jpgSlide 11 and 12 - http://www.flickr.com/photos/noiseprofessor/8249316836/http://commons.wikimedia.org/wiki/File:Burger_King_Paa_Karl_Johan.jpghttp://vipulbansal.deviantart.com/art/Volvo-logo-290965038Slide 23 - http://commons.wikimedia.org/wiki/File:Philip_D_Armour_in_the_1880s.jpgSlide 34 - http://www.flickr.com/photos/normantan/3217802586/Slide 42 - http://pixabay.com/en/man-guy-chair-person-cartoon-40093/

Slide 50 of 49

http://www.flickr.com/photos/mpd01605/3940236658/

http://www.flickr.com/photos/10542402@N06/7334081170/

http://commons.wikimedia.org/wiki/File:Food_Lion_University_Dr_Durham,_NC.jpg

http://www.flickr.com/photos/noiseprofessor/8249316836/

http://commons.wikimedia.org/wiki/File:Burger_King_Paa_Karl_Johan.jpg

http://vipulbansal.deviantart.com/art/Volvo-logo-290965038

http://commons.wikimedia.org/wiki/File:Philip_D_Armour_in_the_1880s.jpg

http://www.flickr.com/photos/normantan/3217802586/

http://pixabay.com/en/man-guy-chair-person-cartoon-40093/

the world of imperfect competition

Education

heavy competition

entry imperfect competition

examples of firms

sellers examples

firms output

large number of firms

roosevelt slide

study of firm behavior