Diploma in Accounting/Banking & Finance/International Business

ECO0006 Economics for Managers

Lecture 5
Profit Maximising under Imperfect
Competition
Tan Khay Boon, Economics for Managers Module Book, SIM
Global Education, 2014
Session 5
Learning Objectives
At the end of the lesson, students will be able to:
1. Explain the behaviour of monopolistic competitive
firms.
2. Explain the behaviour of oligopoly firms.
3. Describe the Nash equilibrium using the Game
Theory Model.
4. Explain the three types of price discrimination.
Imperfect Competition
Monopolistic Competition
Characteristics of Monopolistic Competition
• Large number of buyers and sellers
– small to medium-sized firms
– each firm holds a small share of market
• Differentiated products
– products are close substitutes but not identical
– retain customers even if price is increased due to
unique features of product
– some monopolistic power
• Ease of entry and exit leading to many firms in industry.
• Imperfect knowledge of prices and technology exist.
Characteristics of Monopolistic Competition
Product differentiation:
• Customers are willing to pay a higher price
according to their preferences
• MC firm can charge a higher price because its
product is differentiated
• However output is still subject to the law of
demand
• Firms that charge a higher price will have less
customers
Characteristics of Monopolistic Competition
• Demand curve of each firm is downward-
sloping and highly elastic because of the
presence of many competitors and the
availability of close substitutes
– firm's demand curve will be more elastic the
greater the number of competing firms, and
the less differentiated the firm's product is.
• Marginal revenue curve is below the demand
curve
Characteristics of Monopolistic Competition
Product differentiation can occur in:
• External features
– Different appearances cater to different groups of
consumers
• Quality
– Enhance product such that consumers are more
attracted
– Impacts reputation of product
• Services
– differentiated based on the accompanying services
Characteristics of Monopolistic Competition

• Advertising
– The image that the producer tries to create in the
minds of its consumers
• Price competition
– Target the budget conscious who would only pay
for the bare essentials
 Monopolistic Competition
Equilibrium of the firm
Short run
• MR = MC
• Diagram similar to monopoly except that the AR
and MR curves are more elastic.
• Can make supernormal, normal or subnormal
profits.
 Short-run Equilibrium Of The Firm
Under Monopolistic Competition: Supernormal Profits
Cost MC

ATC

A
P1

B
ATC1

AR = D

MR
Qs Q
O
 Short-run Equilibrium Of The Firm
Under Monopolistic Competition: Normal Profits
Cost MC

P = AC

AR = D

MR
Q1 Output
O
 Short-run Equilibrium Of The Firm
Under Monopolistic Competition: Subnormal Profits
Cost MC

ATC
A
ATC1
P1 B AVC

AVC1
C

AR = D

MR
O Q1 Q
 Monopolistic Competition
Equilibrium of the firm
Long run
– New firms that are attracted to the market would
drive economic profits down to zero (i.e. normal
profits).
– Demand curve (ARL = DL) will shift left until it is
tangent to the LRAC curve.
– In the long run, equilibrium price = PL and
equilibrium output = QL where normal profits are
made only.
 Long-run Equilibrium Of The Firm Under Monopolistic
Competition
Cost
New firms entering Price falls to PL
the industry reduce
demand for each
individual firm.
LRMC

PS
LRAC

PL
ARS

MRS ARL = DL

QL QS MRL
O Q
 Efficiency under Monopolistic Competition
• Productive inefficient
– Does not produce at min LRAC at output QL
• Allocative inefficient
– PL>MCL
– Consumers pay a higher price and get lower output
• However consumers get to enjoy differentiated
products
Imperfect Competition
Oligopoly
 Characteristics of Oligopoly
• A few large firms
– Each firm has a large market share
– Firms decisions will have impact on other firms
– Two firms know as a Duopoly
• Standardised or differentiated product
– Standard bank loans vs differentiated investment
products
• Interdependence of firms: each firm is
affected by its rivals’ actions
 Oligopoly Models
• Competitive Oligopoly
– Strong level of competition lead to near perfect
competition outcomes
– Price cuts and gains for consumers
– Price leadership for more sustainable long term
competition
• Cooperative Oligopoly
– Collusion in the worst case scenario
– All firms work together and behave like a
monopoly
 Cartels
• A formal collusion by firms
• Typically agree on output quotas to control
price
• All the firms’ demand curve form the market
demand curve
• All the firms’ supply curve form the market
supply curve: MC curve
• Price at P1 and aggregate output at Q1
– Divide Q1 out among themselves in the form of
quotas
 The Incentive For A Firm To Produce More Than Its Quota,
Or Undercut The Cartel’s Price
Price/Cost Market MC

The Industry

P1

AR = Market Demand

Market MR
0
Q1 Q
The incentive for a firm to produce more than its quota,
£
or undercut the cartel’s price

Firm is tempted MC
to increase
12 output .

10 Cartel Price
(= MR if price remains fixed)
8

4 AR

2 Firm A
MR
0
200 400 600 800 Q
Oligopoly: Kinked Demand Curve Model
• Assumptions of the model
– One firm reduces price => All will follow in a bid to
retain customers
– One firm increases price => None will follow as they
will gain customers who switch away from the firm
that increases price
 Kinked Demand For A Firm Under Oligopoly
Price
Assumption 1: If the firm
raises its price, rivals will not
Demand is price elastic
D
B Assumption 2: If the firm
P1 reduces its price, rivals will
feel forced to lower theirs too.
Demand is price inelastic

Demand Curve

C
O Q1 Qty
Stable Price Under Conditions Of A Kinked Demand
Price Curve If MC is anywhere
between MC1 and MC3,
MC3 profit is maximised at Q1.
MC2

MC1

P1

b
D = AR

MR
O Q1 Q
 Game Theory Model
Objective: Find solution by considering possible
actions of other players
• 2 Players with 2 strategies each
• Joint outcome for both players
• Each players outcome is dependent on his own
action and the action of the other player
• 4 possible outcomes
 Game Theory Model
Payoff Matrix of Alpha & Beta
Beta
Raise Price Reduce Price

Alpha Raise Price Alpha = $3m Alpha = -$2m

Beta = $3 m Beta = $10m

Reduce Price Alpha = $10 m Alpha = $5 m

Beta = -$2 m Beta = $5 m
 Nash Equilibrium
• Nash equilibrium: Consistent strategies adopted by
each player, given the decision of the other player
• Alpha:
– If Beta raises price, Alpha will reduce price (earn $10m)
– If Beta reduces price, Alpha will reduce price (earn $5m)
• Beta:
– If Alpha raises price, Beta will reduce price (earn $10m)
– If Alpha reduces price, Beta will reduce price (earn $5m)
 Nash Equilibrium
• Both firms will reduce price and earn $5m each
• No matter what the other player does, it is better off
for each player to reduce price
• Reducing price is the dominant strategy for both Alpha
and Beta
– Dominant strategy gives better outcome regardless
of other player’s strategy
• Raising price is a dominated strategy for both Alpha
and Beta
– Dominated strategy gives an inferior outcome
regardless of other player’s strategy
 Prisoner’s Dilemma Game
To confess or NOT to confess??
Bob
Confess Deny
Andrew Confess Andrew = 5 years Andrew = 0 year
Bob = 5 years Bob = 10 years
Deny Andrew = 10 years Andrew = 1 year
Bob = 0 year Bob = 1 year
 Prisoner’s Dilemma Game
• Both prisoner’s are kept in separate cells with no
communication
• Andrew:
– If Bob confesses, Andrew should confess
(5 years)
– If Bob deny, Andrew should confess (0 year)
– Andrew’s dominant strategy is to confess
• Bob:
– If Andrew confesses, Bob should confess
(5 years)
– If Andrew deny, Bob is should confess (0 year)
 Prisoner’s Dilemma Game
• Nash equilibrium: Both confess and get 5
years of jail time each
• Prisoner’s Dilemma: When nash equilibrium
does not give rise to optimal situation
– If both deny, they will get 1 year of jail time
each
• Solution is to cooperate or to collude (stick
to a specific strategy)
 Prisoner’s Dilemma Game
Collusion
• Reward for cooperation and punishment for
non-cooperation
• Game must be played more than once
• Repeat rounds provides incentive for
cooperation and non-cooperation will lead to
retaliation and punishment
 Price Discrimination
To charge different consumers
• different prices for the same product (with
same costs)
• different prices for different quantities
purchased (with same costs)

If cost are different ≠ price discrimination

 Conditions of Price Discrimination
• Distinct markets for different customers
• Different demand elasticities in distinct
markets
– Higher price for market with more price
inelastic demand
– Lower price for market with more price elastic
demand
• No resale of product
– To prevent arbitrage where good in resold to
make a profit
 Types of Price Discrimination
First Degree Price Discrimination
• Each consumer charged maximum price he is willing and able
to pay
• Reservation price
• Known as perfect price discrimination

Second Degree Price Discrimination

• Different price according to quantity purchased
• Batch price discrimination

Third Degree Price Discrimination

• Consumers are grouped in different markets and each
market is charged differently
Profit Maximising with Perfect Price Discrimination
Single price monopolist Vs Price discriminating
monopolist
Price/Cost

A
P1

B C
ATC1 MC=ATC

MR
Output
Q1
Q2
 Discussion Question 1
Is a monopolistically competitive firm productively
efficient?

A. No, because price is greater than marginal cost.

B. No, because it does not produce at minimum
average total cost.
C. Yes, because it produces where marginal cost
equals marginal revenue.
D. Yes, because price equals average total costs.
 Discussion Question 2
Which characteristics apply to an oligopoly?

A. Each firm faces a horizontal demand curve.

B. Many small firms account for a high percentage
of industry output.
C. A few large firms account for a high percentage
of industry output.
D. Each firm faces a downward sloping demand
curve.
 Discussion Question 3
Dough and Coffee operates in a monopolistically
competitive market. Which of the following
characteristics Dough and Coffee's market?

A. Dough and Coffee supplies a small portion of the

market's output.
B. Dough and Coffee's product is slightly different from
its competitors.
C. Dough and Coffee faced no barrier to entry when it
decided to enter its market.
D. All of the above describe Dough and Coffee's
market.
 Discussion Question 4
________ is a group of firms that have colluded
to limit their output and raise their price.

A. A cartel
B. An oligopoly
C. A strategy
D. A duopoly
 Discussion Question 5
Monopolistic competition is a market in which
________ firms produce ________ goods
and services.

A. many; identical
B. many; differentiated
C. few; differentiated
D. few; identical
 Discussion Question 6
The industry producing laptops has many producers producing
a wide variety of laptops with many possible configurations. A
particular laptop producer has discovered a new technology
that enables the entire laptop to be collapsible into a small
cube. Cubist – the new product – has garnered rave reviews
and became an instant hit with the consumers.

a)Explain, with the help of a suitable diagram, the short-run

equilibrium of this producer selling Cubist.

b)Using a new diagram, explain how this short run situation

will evolve in the long-run.
 Discussion Question 7
a) Explain the type of market structure in which each of the
following industries is likely to operate in Singapore:

(i) Fashion apparel

(ii) Pay television

b) Explain the respective type of profits that firms in the

above two industries are likely to earn in the long run.
End of Session 5