Topic 6

Imperfect Competition
Imperfect Competition
and Market Power
 An imperfectly competitive industry is
an industry in which single firms have
some control over the price of their output.
 Some examples are Monopoly, Oligopoly
and Monopolistic competition.
 Market power is the imperfectly
competitive firm’s ability to raise price
without losing all demand for its product.

2
Price: The Fourth Decision Variable
 Firms with market power must
decide:
• how much to produce,
• how to produce it,
• how much to demand in each input
market, and
• what price to charge for their
output.

3
Monopoly

A market structure in which only one

producer or seller exists for a product
that has no close substitutes

Magic
Lamps,
Inc.

4
Characteristics of Monopoly

 The degree of control over price that is

held by the monopolist
 The individual supply of the monopolist
coincides with the market supply
 Market demand equals the demand for the
monopolist’s product or service
 The monopolist is a “price maker”

5
Sources of Monopoly
 Economies of scale
 In capital intensive industries, the economies
of large-scale production may lead to a small
number of firms producing the product
 Natural monopolies: Public utilities
 In cases where one or two firms can
adequately supply all the service needed, it
may be desirable to limit the number of firms
within a given territory
 Government regulation of these monopoly
franchises

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Sources of Monopoly
 Control of raw materials
 An effective barrier to entry is ownership or
control of essential raw materials
 Effective for years in the production of
aluminum
 ALCOA and its control of bauxite

 Patents
 The exclusive right to use, keep, or sell an
invention for a period of 20 years
 Threat of infringement suits
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Sources of Monopoly Power

 Competitive tactics
 Aggressive production and
merchandising techniques
 Illegal predatory pricing policies
 Aggressive innovation techniques

8
Determining Monopoly Price
 The monopolist’s demand curve
slopes downward to the right because
it is the market demand curve of all
consumers
 The first question the monopolist asks
is, “How many units of my good can I
expect to sell at various prices?”

9
Price and Output Decisions in
Pure Monopoly Markets
 With one firm in a monopoly market,
there is no distinction between the
firm and the industry. In a monopoly,
the firm is the industry.
 The market demand curve is the
demand curve facing the firm, and
total quantity supplied in the market
is what the firm decides to produce.

10
Price and Output Decisions in
Pure Monopoly Markets
Monopoly
Demand Curve

 The demand curve facing a perfectly competitive firm is

perfectly elastic; in a monopoly, the market demand
curve is the demand curve facing the firm.
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The Monopolist’s Demand Curve
Price

TR =$10,800
$12

10 TR = $10,000

8 TR = $8,800

0 900 1,000 1,100 Quantity

12
The Monopolist’s Cost Curves

 The monopolist’s cost curves reflect

the law of diminishing marginal
productivity
 Thus, the cost curves have the same
general shape and characteristics as
the cost curves in a competitive
industry
13
Marginal Revenue Curve
Facing a Monopolist
 For a monopolist, an
increase in output involves
not just producing more
and selling it, but also
reducing the price of its
output to sell it.
 At every level of output
except one unit, a
monopolist’s marginal
revenue is below price.

14
Cost and Revenue Curves for a Monopoly
$20
19 Profits maximized where MR = MC
18
17
16
15 If the ATC curve is
ATC
Price and Cost

14
MC higher than the AR
13 curve, the monopolist
12
11
would incur a loss
B P
10
9 PURE
8 B′ PROFIT C
7 MR will be less than
6 AR or demand
5 AR because the
4 A
3
monopolist must
2 lower price to
Q MR
1 increase sales
0
1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity
15
Facts about Monopoly
 A monopoly firm has no supply curve that is
independent of the demand curve for its product.
 A monopolist sets both price and quantity, and the amount
of output supplied depends on both its marginal cost curve
and the demand curve that it faces.
 Since entry is blocked, the monopolist can earn
economic profits in the long run.
 Monopolists can earn losses in the short run if
demand is not sufficient or if costs are too high.

16
Price and Output Choices for a Monopolist
Suffering Losses in the Short-Run
 It is possible for a
profit-maximizing
monopolist to suffer
short-run losses.
 If the firm cannot
generate enough
revenue to cover
total costs, it will go
out of business in
the long-run.

17
Perfect Competition and
Monopoly Compared

 Relative to a competitively organized industry, a

monopolist restricts output, charges higher prices,
and earns positive profits.
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Monopolistic Competition
 Monopolistic competition is a common
form of industry (market) structure,
characterized by a large number of firms,
none of which can influence market price
by virtue of size alone.
 Some degree of market power is
achieved by firms producing
differentiated products.
 New firms can enter and established
firms can exit such an industry with
ease.
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Product Differentiation

Establishment of real or imagined

characteristics that identify a firm’s
product as unique

Vs.

20
Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
 Based on the availability of
substitutes, the demand curve
faced by a monopolistic
competitor is likely to be less
elastic than the demand curve
faced by a perfectly
competitive firm, and likely to
be more elastic than the
demand curve faced by a
monopoly.

21
Substitution Effect

 A change in quantity demanded of a

good due to a change in the price
relative to substitute goods
 Increased sales at the expense of other
firms

22
Monopolistic Competition in the Short Run
 In the short-run, a monopolistically competitive
firm will produce up to the point where MR = MC.

• This firm is
earning positive
profits in the
short-run.

23
Monopolistic Competition in the Short-
Run
 Profits are not guaranteed. Here, a firm with a
similar cost structure is shown facing a weaker
demand and suffering short-run losses.

24
Monopolistic Competition in the Long-Run

 The firm’s demand curve

must end up tangent to its
average total cost curve for
profits to equal zero. This
is the condition for long-run
equilibrium in a
monopolistically
competitive industry.

25
Short-Run Cost and Revenue Curves: Possible
Equilibrium Under Monopolistic Competition
The demand curve facing each firm is downward sloping because of product
differentiation and is more elastic than with a monopoly  the firm will be able to
increase sales by lowering price
Industry Short-Run Economic Profit Long Run
MC
$ $ $ MC
S
ATC
ATC
Profit
AR
D AR
MR MR
0 Quantity 0 30,000 Quantity 0 28,000 Quantity
The general range of A monopolistic In the long run, the
prices established in the competitor that is firm in an
industry around the earning an monopolistically
intersection of total economic profit competitive industry
supply and demand because AR is will just earn normal 26
higher than ATC profits
Economic Efficiency
and Resource Allocation
 In the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,
however:
• Price is above marginal
cost. More output could be
produced at a resource cost
below the value that
consumers place on the
product.
• Average total cost is not
minimized. The typical firm will
not realize all the economies of
scale available. Smaller and
smaller market share results in
excess capacity.
27
•Notice that the LR equilibrium quantity is to the left of the minimum ATC curve.
Oligopoly
 A market structure in which relatively few
firms produce identical or similar products
 Two basic characteristics:
 Each firm has some ability to influence price
 The interdependence among firms in setting
their pricing policies
 Entry barriers exist.

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Possible Demand Curves for an Oligopolist

Price D1 The effect on sales when an oligopolist

changes price depends on the reaction of its
D competitors

Competitors may choose

P
P to do nothing
Competitors may match
any change in price
D
Rivals may follow suit for a
decrease in price, but ignore an
increase in price
D1
Q Quantity
A kinked demand curve results if rivals follow suit for a P↓ but ignore a P↑
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Competition in Oligopoly
 Firms in oligopolies tend to
concentrate on nonprice competitive
policies like advertising
 Frequently use administered prices
 A predetermined price set by the seller
rather than a price determined solely
by demand and supply in the
marketplace
 Use of nonprice competition eg rebates,
promotional deals, etc.. 30
Cartel
 An organization of independent firms that
agree to operate as a shared monopoly by
limiting production and charging the
monopoly price
 Key ingredients for cartel success
 Small number of firms
 Substantial barriers to entry
 Homogenous product
 Violations of the agreement are easily
detected

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Three-Firm Cartel
Price
The firm will maximize profits by equating its MR with MC
 price equal to P and will produce q1
The demand and marginal revenue curves for one of the
three identical firms = one-third of market demand

P The end result is that the

cartel will charge a monopoly
FIRMS 2 + 3
price and restrict output to the
MARKET
SHARE MC1 monopoly level (Qc)
FIRM 1
MARKET Dc
SHARE Demand curve for cartel’s product

MR1 d1
q1 Qc Quantity

32
Measurements of Concentration
 Concentration ratio
 A measure of market power calculated by
determining the percentage of industry output
accounted for by the largest firms
 Herfindahl Index
 A measure of market power calculated by summing
the squares of the market shares of each firm in the
industry
 Gives much great weight to firms with large market
shares. A HI value of <1000 indicates a highly
competitive industry.
33
 Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms
in High-Concentration Industries, 1992
FOUR EIGHT NUMBER
SIC INDUSTRY LARGEST LARGEST OF
NO. DESIGNATION FIRMS FIRMS FIRMS
2823 Cellulosic man-made fiber 98 100 5
3331 Primary copper 98 99 11
3633 Household laundry equipment 94 99 10
2111 Cigarettes 93 100 8
2082 Malt beverages (beer) 90 98 160
3641 Electric lamp bulbs 86 94 76
2043 Cereal breakfast foods 85 98 42
3711 Motor vehicles 84 91 398
3482 Small arms ammunition 84 95 55
3632 Household refrigerators and 82 98 52
freezers
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios34
in Manufacturing, Subject Series MC92-S-2, 1997.
Perfect & Imperfect Markets Compared
 High degree of competition benefits
consumers
 Under perfect competition, firm tend to
have lower prices, produces more outputs
and obtain normal profits in the long run.
 Each firm produces at the minimum ATC
curve and P (AR) = MC (and ATC).

35
Perfectly Competitive versus Monopolistic Pricing:
Possible Long-Run Price Under Monopolistic Competition

Monopolistic competitive
solution: PQ
Competitive solution: P`Q`

MC
Price and Cost

ATC
K
P
C
P′ D´ (MR´ and AR´)

B
AR
MR
0 Q Q′ Quantity
36
 Possible Equilibriums Under Perfect
Competition, Monopoly, and Oligopoly

$ $ MC
MC

ATC ATC
AR
and
MR

AR
MR
0 100,000 Q 0 500,000 Q
Perfect Monopoly or
Competition Oligopoly

37
Competition Among Consumers
 Monopsony
 A market structure in which there is a single
buyer (e.g., rural area granary)
 Oligopsony
 A market structure in which there are only a
few buyers (e.g., tobacco market)
 Monopsonistic competition
 A market structure in which there are many
buyers offering differentiated conditions to
sellers (e.g., toy manufacturers)
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