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Lecture 5 Profit Maximising Under Imperfect Competition
Lecture 5 Profit Maximising Under Imperfect Competition
Lecture 5 Profit Maximising Under Imperfect Competition
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
A
P1
B C
ATC1 MC=ATC
MR
Output
Q1
Q2
Discussion Question 1
Is a monopolistically competitive firm productively
efficient?
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.