Module 8: Imperfect Competition

UNIT LEARNING OUTCME

At the end of the unit, you are expected to:

1. Determine the profit-maximizing behavior of firms in the imperfect competition.

2. Compare and contrast the profit-maximizing behavior of firms in the perfect and imperfect
competition.
3. Explain the process of maximizing the profit of a firm in imperfect competition.

BIG PICTURE IN FOCUS

Perfect competition is an ideal market in which firms are price takers, and consumers enjoy the benefit of
competition in an almost level playing field. However, a perfect market is hard to come by. Most of the
things we want and take for granted, such as the laptop from Acer, Apple, or Asus or the pizza from S&R,
Shakey's, or Pizza Hut, are large firms that impose a certain level of control on prices. Indeed, there are
only very few firms that dominate particular industries. It is the real business world and imperfect
competition.

Compared to perfect competition, in imperfect competition, prices are higher, and output is lower.
However, imperfect competition has its advantages. The economies of scale lowering the production cost,
as more output produced happened in a large firm. Also, large firms are responsible for undertaking R&D
that sustain long-term economic growth. The mechanism of imperfectly competitive markets is explained
in an industrial economy.

There are very few markets in the economy that qualifies in perfect competition. For instance,
automobiles, petroleum, airlines, power and water utilities, computer software, rice, and chicken. Can
you identify the goods sold in a perfectly competitive market? The automobiles, petroleum, and airlines
are not part of perfect competition. There are only two airlines companies that dominate the local market,
Cebu Pacific and Philippines Airlines. Also, in the Philippines, there are only three major players in the oil
industry. Three are four automakers dominate the local car industry. Only a few large firms dominated
these industries.

On the other hand, power and water utilities are dominated by only one firm that hardly meets perfect
competition characteristics. The Davao Light and Power Utility singly dominate the distribution of power
in Davao City. Why does the government allow such a firm to dominate the market? We will find it very
difficult to generate enough electricity to meet the power needs of our households. Inspecting the list
above, we can declare that only rice and chicken qualifies in our definition of perfect competition.

Imperfect competition exists if the firm can influence the price of their output. Monopoly, oligopoly, and
monopolistic competition are significant kinds of imperfect competition. Firms in imperfect competition
do not have absolute control over the price of their product. For example, in the beverage market, where
Pepsi and Coke dominate the market, imperfect competition exists. If Coke and Pepsi sell their product at
P50 per litter, Zesto, a local player, may set their product's price at P45 or P55 and remain profitable.
Zesto cannot set the price at P20 per liter. It will drive them out of business.

In imperfect competition, firms have a partial to complete control over its price. Further, the level of
control varies from industry to industry. In specific markets, the firm's level of monopoly is complete that
the firm is the industry. For instance, in a power utility company, the government granted an exclusive
franchise. The firm price-setting always has a significant effect on the market. By contrast, a tomato
farmer has to take the price existing in the market. Setting his price higher or lower is not sustainable for
him.

METALANGUAGE

Monopoly, oligopoly, and monopolistic competitive firms are parts of the imperfect market.

Product differentiation is a technique firms employ in a standardized product to distinguish their product
from other firms.

The government uses tariffs, franchises, and patents to restrict the entry of firms in the market.

Marginal revenue (MR) is the additional revenue the firm earned by producing an additional output level.

Marginal Cost (MC) is the additional cost firm incurred by producing an additional output.

ESSENTIAL KNOWLEDGE

Types of imperfect competitors

As an emerging economy such as the Philippines is a menagerie of various types of imperfect competition.
The interactions of forces in the smartphone industry energized with technology improvement are distinct
from the competition existing in the funeral industry. Nonetheless, cautious attention to an industry's
market structure, specifically on the market leaders and many sellers, reveals so much information on the
industry.

If we lined up the imperfect competitors in a spectrum, monopoly occupies farthest from the perfect
competitors. A monopoly is a single seller with massive power over the industry, selling the product in a
market with many buyers and no close substitute. A monopolist does not practice price discrimination,
selling the products at a standard price. Presently, most monopolists are heavily controlled by the
government regulatory agency. For example, the Energy Regulatory Board (ERB) regulates the power
utilities which the government granted an exclusive franchise.

However, monopolists do not always have complete control in the market. There are still potential
competitors that may enter the market. For instance, a pharmaceutical company may discover that a rival
company may offer a better drug; Nokia, a mobile phone monopolist several decades ago, faced stiff
competition from the Apple smartphone technology, which finally ended its market dominance. A
monopolist does not indefinitely enjoy complete control over the market.

Oligopoly pertains to a few sellers in the market, which ranges from 2 to 15 firms. A firm in an oligopoly
can affect the price of the good in the market. For instance, the local airline industry has two major
players. One airline's decision to reduce fare may initiate a price war, prompting all players to lower
fares.

The monopolistic competition combines both the characteristics of a monopoly and perfect competition.
Many sellers produce differentiated products similar to perfect competition in the presence of many
sellers, which cannot significantly affect the prices in the market. The perfect competition is the
differentiation of the product which the various firm tried to highlight in the market. For example,
smartphones have different features and functionalities. Manufacturers differentiate these
characteristics to vary prices offered in the market.

A typical example is that you may go to a local drug store to buy your vitamins, though the price is slightly
higher because it is on your way to school. However, if the drug store's price rises for several pesos, you
may choose to buy from Mercury drugstore or at Watson an out of your way. It demonstrates the
importance of location in product differentiation. You have to spend some time going to the store, bank,
or grocery to do your errands and needed time to buy your preferred choices. Even though stores are
known for offering goods at lower prices, people still tend to shop at a store near their residence. The
time needed to go to the store involved opportunity cost and other non-monetary reasons involved cost.
It is the reason large malls and shopping complexes are popular. They offer convenience by the variety of
shops in their location. Presently, internet shopping is becoming popular, even with the added cost of
shipping, it is still costly to go to the mall, choose the goods, pay, and return home. Internet shopping
offers more convenience.

Today, consumers increasingly want quality in their product, which is an essential trait of differentiation.
Different characteristics and prices separate the goods from other similar products. Most smartphones
run on android, and there are many manufacturers of phones. Nevertheless, many smartphone producers
differ in size, color, features, and much more, it is an example of monopolistic competition.

Causes of Market Imperfections

We may wonder why some markets are near perfect, while others can only accommodate one or two
firms. There are two significant causes of imperfect competition—initially, there are specific goods that
required economies of scale to produce and a much-reduced cost. For instance, power utilities to generate
and distribute single kilowatt-hours of electricity required colossal infrastructure. For the consumer to
afford electricity, it depends on the economies of scale to reduce the cost. Suppose two or three power
utilities exist. The cost of production increase that most consumers may not afford its cost. Secondly,
imperfect competition arises due to "barriers to entry," which serve as an obstacle for others to enter the
market. The government may require a license or franchise before allowing a firm to operate in the
market. In some cases, economic factors make it difficult for others to enter the market, such as massive
capitalization or high technical requirements cause imperfect competition.
Barriers to entry are a significant reason for firms to enter the market freely. A high barrier will only allow
very few competitors. Previously the economies of scale are a common type of barrier. Also, government-
issued franchises increased investment cost, and product differentiation serves as barriers to entry. The
government sometimes limit competition through patents, franchise, import tariffs, or quota. A firm with
a patent has the exclusive right to produce and distribute the product in the market.

In many industries, the government imposes entry restrictions such as telecommunications, power and
water utilities, and commercial broadcast—the government award firms with a franchise an exclusive
right to produce the product or service. In return, the firm has to abide by the regulatory requirement of
a government bureau.

Free trade promotes a brisk competition among rivals. Tariffs are taxes on imported goods that restrict or
limit foreign competitors' ability to enter the local market. The government may observe that the local
market can only support two or three local firms, while the global market may support many firms. The
government in allowing foreign competitors to compete in the local market may eventually kill the local
firms.

Aside from government restrictions, the high entry cost serves as another barrier to entry in the market.
In specific industries, the cost of entry is very high. For example, the telecommunication industry needs a
massive amount of investment to enter the market. It is likely that only two telecommunication providers,
SMART and GLOBE, presently exist in the country. Also, companies need franchise approval and other
intangible forms of investment to start a telecommunication company. In consideration, the software
industry, Microsoft (Excel and Word), has a strong dominance in the market that any potential entrant
needs to invest in a massive investment to attain wide market acceptability. Thus, potential entrants may
find it difficult to set a foothold in the market. Most users who have comfortably used the program are
hesitant to switch to another.

Advertising used to differentiate a brand from other products significantly creates a formidable barrier to
entry. Firms resort to advertising to increase product awareness and strengthen loyalty in the market. For
instance, many industries, beverage, smartphones, laundry soap, and shampoo allocate millions of pesos
in the advertisement to make it very expensive to potential rivals to enter the industry. Aside from
advertisement costs, monopolistic firms produce a vast collection of brands, models, and products. The
variety of brands and models appeal to a broader range of customers. At the same time, the massive array
of differentiated products in the market discouraged potential entrants.

Monopoly Behavior

Firms in an imperfect competition behave differently compared to firms in perfect competition. There is
a different concept of marginal revenue. One thing is sure, monopolistic practices always led to
inefficiently high process and low outputs, which decreases buyer welfare

A firm in an imperfect competition wanted to maximize profit. How will they do it? At what price and at
what level of output? In answering these questions, we need to revisit the concept of marginal revenue.
Previously we know that there is a correlation between price and quantity sold. In determining the total
revenue (TR), we get the product of price and quantity. However, unlike perfect competition, sellers are
price takers. In the case of imperfect competition, firms have a certain level of control in price. Though
these firms still follow the law of demand, they can only sell more if they decrease the price. Thus at an
initial price of P20 per unit, the demand is zero units, reducing the price to P14 per unit, the quantity is at
30 units, the TR (P14/unit x 30 units) is P420, the average revenue (AR) (P600/30) is P14. Still, the marginal
revenue [(420-320)/(30-20)] is P10.

Q TR=P X Q P=AR =TR/Q ∆𝑇𝑅

MR=
∆𝑄

0 0 20
10 180 18 18
20 320 16 14
30 420 14 10
40 480 12 6
50 500 10 2
60 480 8 -2
70 420 6 -6
80 320 4 -10
90 180 2 -14
100 0 0 -18

In the table above, the TR initially increases as the output increase as the price (P) decreases. The firm
needs to sell more output, which is favorable to the firm since the upper range, the demand is elastic until
the price level reaches the midpoint, at the maximum TR was reached at P500. Notably, if the output was
further increased, TR decreased since the demand is already inelastic. Previously we know that the
percentage increase in price is greater than the percentage increase in quantity demand, which eventually
TR will start to decrease. Significantly, the maximum TR is reached at 50 units at the price of P10 per unit.
The figure below shows that the demand curve in an imperfect competition is the average revenue (AR
=D). Specifically, regardless of the demand, the AR is always positive, though the MR is already negative.
The figure for the TR is a domed shape that peaks at 50 units.

AR = D & MR
25
20
15
10
5
0
-5 0 20 40 60 80 100 120

-10
-15
-20

AR = D MR
 TR=P X Q
600

500

400

300

200

100

0
0 20 40 60 80 100 120

At this point, let us highlight the relationship between elasticity and marginal revenue. If the demand is
elastic, the MR is positive, if elasticity is unitary, MR is zero (0), and if demand is inelastic, the MR is
negative. The concept implies our previous topics that if demand is elastic, a decrease in price causes the
TR to increase. On the other side, if demand is inelastic, a reduction in price causes TR to decrease. As a
reference to the previous table above, the MR is negative. A decrease in price results in a decrease in TR.
Suppose the price is P8 per unit, the quantity demand is 60 units with TR equal to 480, reducing the price
to P6 per unit, the quantity demand increase to 70 units, the MR is -6, but the TR is reduced to 420. Hence,
if the MR is negative, further reducing the price results in a decrease of TR.

There are several points to remember the relationship between elasticity and MR

1. Marginal revenue is the additional income earned by producing an additional unit of output.
2. Average revenue is the quotient between total revenue and number of units produced, P = AR
3. With imperfect competition, P > MR.
4. At elastic demand, MR is positive, and at inelastic demand M is negative.
5. In a perfect competition, P = MR = AR.

Maximizing profit in Imperfect Competition

It is still an essential question even among firms in an imperfect competition that seeks to determine how
to maximize profits. Mathematically, profit is the difference between total revenue (TR) and total cost
(TC). In the table below, the firm's maximum profit is at the level where the marginal revenue (MR) is
equal to the marginal cost (MC). The table below depicts that a monopolist maximizes profit at 50 units
at P300, which requires a price of P10 per unit. The firm earned a total revenue of P500 and a total cost
(TC) of P300. Compared with other prices at P10 per unit maximizes the profit of the firm. As a better
insight, we can compare the MC and MR column. The firm continues to increase profit as long as the MR
is greater than the MC. It means that the additional output provides more revenue than cost;
consequently, the profit will increase. Thus, the firm needs to increase production as long as MR is greater
than MC. However, if the MR is less than MC, the additional revenue earned is less than the additional
cost incurred by producing an additional output unit, which reduces profit as the firm continues to
increase output. Suppose the firm decided to produce 70 units, the TR is P420 and the MC is P272 with a
profit of P148. At the price of P6 per unit and MR -P6 and an MC at P5. Notably, increasing output at 80
units, the profit decreases to –P12, while the MR is less than MC. Therefore, a monopolist firm's maximum
profit is the output wherein the MR is equal to MC, -P10 and P6.

Q TR TC AC Profit P MR MC
-
0 0 50 -50 20 - -
9.5
10 180 95 85 18 18 4.5
6.35
20 320 127 193 16 14 3.2
5.166667
30 420 155 265 14 10 2.8
4.5
40 480 180 300 12 6 2.5
4
50 500 200 300 10 2 2
3.7
60 480 222 258 8 -2 2.2
3.885714
70 420 272 148 6 -6 5
4.15
80 320 332 -12 4 -10 6
4.622222
90 180 416 -236 2 -14 8.4
5.16
100 0 516 -516 0 -18 10

The figure for profit maximization below shows where the MC intersects the MR. The firms realized the
maximum profit. The price is determined on the demand curve above the intersection between the MR
and MC at P10 per unit. As depicted, the price (P) is above the average cost (AC). The shaded yellow
rectangle is the profit. It can be computed as the rectangle area that is the product of width and height,
which is P300 (50 x 6). Likewise, profit can be calculated as the difference between price (P), and average
cost (AC) multiplied with the number of units produce (P – AC) x Q. The next figure portrayed the
maximization of profit used the total concept instead of the marginal concept. The difference between
the TR and TC is the level of profit. The TC is continuously increasing as additional input increases, while
the TR initially increases until it peaks at 50 units and eventually decreases.
 Profit Maximization
25
20
15
10
5
0
-5 0 20 40 60 80 100 120
-10
-15
-20

AR MR MC AC

Total Cost, Revenue, Profit

600

400

200

0
0 20 40 60 80 100 120
-200

-400

-600

TR TC Profit

Perfect competition in comparison to Imperfect Competition

Previously imperfect competition, the MR=MC has been applied to identify the maximum profit equally
applicable in perfect competition. There are two steps identifiable:

1. Focusing on the MR behavior in the perfect competition does not increase or decrease as the
number of units produces increases. In perfect competition, the price is equal to MR, whereas
an increase in output does not decrease price. Also, under perfect competition, the price (P) is
equal to average revenue (AR) equals marginal revenue (MR), (P = AR = MR). Conversely, in
imperfect competition, the demand curve is the average revenue, while the individual firm has a
demand and MR as a horizontal line.

2. For perfect competitors, the P = MR = MC. Contrarily, there is a difference in imperfect

competition. The P=MR=MC rule applies in the perfect competition since the firm can sell as many
units it desires. On the other side, in imperfect competition, a firm needs to reduce the price to
 increase sales. While firms in perfect competition are price takers, imperfect competition firms
have a specific level of control in price.

Marginal analysis is essential in economics, though it will not make us instantaneously wealthy.
Subsequently, it leads us to a useful way of thinking about costs and benefits. The previous chapters' vital
lesson was to look closely at the marginal cost and marginal benefits of decisions and disregard the past
or sunk cost. The marginal analysis teaches us to focus on the present and learn from the past. In any
decision, there are a corresponding added cost and added benefits. The marginal principle leads
businesses to the maximization of profits by comparing the marginal cost and marginal benefits.

SELF-HELP

The first article identified the advantages and disadvantages of monopoly. Moreover, the second article
describes the pricing model of oligopoly. Specifically, the kinked demand curve that occurs in a
competitive oligopoly.

Monopoly
https://www.economicshelp.org/microessays/markets/monopoly/

Oligopoly Pricing Models

https://thismatter.com/economics/oligopoly-pricing-models.htm

LET’S CHECK

Answer the following questions:

1. A monopolist firm that owns a distilled water distributor,

a. Suppose the cost of production is zero. Determine the demand elasticity at the profit-
maximizing quantity.
b. Suppose the MC is constant P1 per unit, determine the demand elasticity at profit-
maximizing quantity.

2. Explain why the following statement is NOT true.

a. If MC=P is the maximum profit for a monopolist
b. The higher is the elasticity. The higher is the price above MC.
c. A monopolist can ignore the marginal principle.
d. A monopolist wanting to maximize profit will offer more than perfect competitors at a
lower price.
3. If demand elasticity is unitary, what is the MR's value? Explain
 LET’S ANALYZE

Complete the table below and graph the AR, MR, MC, and AC

Q Price TR AR MR TC MC Profit
0 30 70
5 27 135
10 24 197
15 21 252
20 18 300
25 15 345
30 12 383
35 9 428
40 6 478
45 3 533
50 0 593

Provide a brief explanation of the firm's behavior to set production at 20 units at the price of P18 per
unit.

IN A NUTSHELL

Portrayed in this unit is firms' behavior in imperfect competition, wherein there is a lack of economic
competition in the production of goods and services. There is a difficulty in standardized the product due
to the high level of differentiation. Often, firms are not price takers. They exercise a specific level of price
control. Firms have a lower marginal cost at a lower production level and increase at a higher output
level. Comparatively, perfect competition maximizes profit at a condition wherein the price is equal to
marginal revenue, similar to marginal cost. For monopolies, marginal revenue is downward-slopping, and
the average revenue traces the demand. Also, the marginal revenue for monopolies is always less than
the price. Please state three reasons for the monopolist to have a downward sloping marginal revenue.

1.

2.

3.