Ch. 11 Imperfect Competition & Strategic Behavior

Imperfectly Competitive firms engage in non-price competition

1) Advertising: firms attempt to shift demand curve and attract customers 2) Product quality: offering competing standards of quality and product guarantees 3) Entry barriers: engage in activities designed to hinder entry of new firms, preventing declines in profit.

Important Firm-created Entry barriers

1) Brand proliferation 2) Advertising: 3) Predatory pricing

Assumptions of Monopolistic Competition

1) Differentiated products: firms face negatively-sloped highly elastic demand curve (due to competing firms producing many close substitutes) 2) All firms have access to same technological knowledge: same cost curves 3) Large number of small firms: each firm ignores reactions of its many competitors when making price and output decisions 4) Freedom of entry and exit in industry

Major types of Competitive Behavior

1) With differentiated products, compete by lowering prices in hope to attract customers from rivals (cellphone service providers, banks) 2) Actively engage in non-price competition through product quality, advertising campaigns (fast food, electronics, familiar consumer products) 3) Developing new products or making significant improvements

Price-setter

A firm that faces a downward-sloping demand curve for its product. It chooses which price to set.

differentiated product

A group of products similar enough to be called the same product but dissimilar enough that they can be sold at different prices.

A Monopolist would most likely NOT advertise

A monopolist has no competitors in the industry, and so will not advertise to attract customers away from other brands. In some cases, they will in order to convince consumers to shift their spending away from other types of products and toward the monopolist's product.

Advertising

Ads establish strong brand images for existing products; a new firm will have to spend heavily on ads to create own brand images in consumers' minds. A new entrant with small sales but large required advertising costs finds itself at a substantial cost disadvantage relative to its established rivals.

Collusion

An agreement among firms to act jointly in their common interest. Collusion may be overt or covert, explicit or tacit.

Cooperative outcome

An equilibrium in a game where the players agree to cooperate (where highest joint profits will be earned if each firms produces 1/2 of the monopoly output). Can only be achieved if firms have some effective way to enforce their output-restricting agreement.

Nash Equilibrium

An equilibrium that results when each player is currently doing the best it can, given the current behavior of the other players.

Oligopoly

An industry that contains two or more firms, at least one of which produces a significant portion of the industry's total output.

Duopoly

An oligopoly consisting of only two firms

Strategic Behavior

Behavior that is designed to take account of the reactions of one's rivals to one's own behavior.

Non-price competition

Competition based on factors other than price as a means to attract customers away from competing firms.

Profit maximization for Oligopolies is Complicated

Determining level of output (where MR=MC) is complicated because the firm's marginal revenue depends on what its rivals do.

SR Decision of Monopolistic Competitively Firm

Face negatively sloped demand curve and maximizes profits by choosing its level of output such that MC = MR (similar to monopoly). It is possible for a firm to make profits, losses or break-even in the short run.

Tacit collusion

Firms behave cooperatively without any explicit agreement to do so because each firm recognizes that maximizing their joint profits is in its own interest.

Basic dilemma of oligopoly

Firms can either cooperate (collude) in attempt to maximize joint profits, or compete in an effort to maximize individual profits. If the firms are at a cooperative outcome, it will be worthwhile for any one of them cut its price or raise its output, as long as the others do not do so. If every firm does the same thing, they will be worse off as a group and possibly worse off individually.

Competitive behavior

Firms in an oligopoly choose to compete actively with each other in an attempt with each other in an attempt to attract customers away from their rivals, increase their overall share of the market, and increase their profits. Competition benefits consumers because they result in lower prices, better products/services and innovation.

Note on Nash Equilibrium

If Nash Equilibrium is established whatsoever, no firm has an incentive to depart from it by altering its own behavior. Basis is rational decision making in the absence of cooperation.

Non-cooperative outcome

If each firm thinks the other will cooperate, then it has an incentive to cheat and produce more than the restricted output. Firm's A profits will be high if it produces 2/3 of the monopoly output no matter what Firm B does.

Notes on LR Equilibrium

In LR equilibrium in monopolistic competition, goods are produced at a point where average total costs are not at their minimum. From society's point of view, there is a tradeoff between producing more brands to satisfy diverse preferences and producing fewer brands at a lower cost per unit.

Imperfectly Competitive firms set their prices

In imperfect competition, most firms set their prices and then let demand determine sales. Changes in market conditions are signaled to the firm by changes in the firm's sales. Prices change less frequently in imperfect competition rather than perfect competition. Imperfectly competitive firms respond to fluctuations in demand by changing output and holding prices constant. Only after changes in demand are expected to persist, firms adjust their entire list of prices.

Final note on Oligopoly

It is an important market structure in modern economies because there are many industries in which MES is too large to support competing firms. Challenge to public policy is to keep oligopolists competing, rather than colluding, and using their competitive energies to improve products, reduce costs, instead of only creating entry barriers.

Oligopoly and Innovation

It is argued that the oligopolist faces strong competition from existing rivals and cannot afford the relaxed life of the monopolist. From profits earned from innovative activity, they have more incentive to innovate.

Defining the market

Main problem associated with using concentration ratios is to define the market with reasonable accuracy.

Monopolistic Competition

Market structure in which there are many firms and freedom of entry and exit but in which each firm has a product somewhat differentiated from the others, giving it some control over its price.

Industries with many small firms

Monopolistic competition explains economic behavior and outcomes in industries where there are many small firms, but where each firm has some degree of market power.

Imperfectly Competitive firms differentiate their products

Most firms in imperfectly competitive markets sell differentiated products. In such industries, the firm itself must choose its product's characteristics.

Industries with few large firms

Oligopoly helps us understand industries with a small number of large firms, each with considerable market power, and that compete actively with each other. Common in developed economies where industries consist of few very large firms that dominate the market.

Oligopoly and the Economy

Oligopoly is found in all advanced economies and occurs in industries with significant economies of scale (not enough room for large number of firms to operate at minimum efficient scale).

Game theory applied to oligopoly

Players are firms, their game is played in the market, their strategies are their price or output decisions, and the payoffs are their profits.

LR Equilibrium of a Monopolistic Competitively Industry

Profits provide incentive for new firms to enter the industry, and total demand for industry's product must be shared among firms (each firm gets a smaller share of the total market). Each entry shifts the demand curve faced by each existing firm to the left. Entry continues until profits are eliminated.

Predatory pricing

Selling a product below cost (when entry occurs) for a short period of time to drive competitors out of the market. It sends a discouraging message to future rivals and present ones. Although profits are lost in the SR, it may pay for itself in the LR by creating reputation effects that deter entry of new firms. (illegal in Canada)

Profits Under Oligopoly

The extent to which price remains above and output below competitive levels, oligopoly will be less efficient than perfect competition; with welfare loss for society as a whole. In LR, profits that survive competitive behavior among existing firms will attract entry. Profits will persist if entry is restricted by natural or created barriers.

Brand proliferation

The larger the number of differentiated products that are sold by existing oligopolists, the smaller the market share available to a new firm entering with a single new product.

Excess-capacity theorem

The property of long-run equilibrium in monopolistic competition that firms produce on the falling portion of their long-run average cost curves. This results in excess capacity, measured by the gap between present output and the output that coincides with minimum average cost.

Edward Chamberlin

The theory of monopolistic competition was originally developed to deal with the phenomenon of product differentiation. Theory was first developed by US economist in his pioneering 1933 book The Theory of Monopolistic Competition.

Game theory

The theory that studies decision making in situations in which one player anticipates the reactions of other players to its own actions.

Cooperative (collusive) outcome

a situation in which existing firms cooperate to maximize their joint profits

Payoff matrix

a table that shows the payoffs that each firm earns from every combination of strategies by the firms (basic structure used for decisions to build new factories, launch advertising campaigns, adjust prices of differentiated products)

Non-cooperative outcome

an industry outcome reached when firms maximize their own profit without cooperating with other firms

industrial concentration

an industry with a small number of relatively large firms is said to be highly concentrated. a formal measure of such industrial concentration is given by the concentration ratio. Firms may be large, but low concentration ratios suggest that they have quite limited market power.

A Perfectly Competitive Firm will NOT advertise

because the firm faces a perfectly elastic (horizontal) demand curve at the market price, so advertising would involve costs but would not increases the firm's revenues.

Explicit collusion

cooperation involving direct communication (an explicit agreement) between competing firms about setting prices and restricting output.

concentration ratio

the fraction of total market sales controlled by a specified number of the industry's largest firms