VIII.

Imperfect
Competition
Chapter 11
In this chapter you will learn
• The key characteristics of oligopoly;
• How game theory is used to study the strategic
behaviours of oligopoly firms;
• Define and identify monopolistic competition
• Compare monopolistic competition with monopoly
and perfect competition in the short run and long run;
THE LANDSCAPE OF FIRMS
YOU ARE
Perfect
• HERE
competition
Monopolistic Oligopoly
competition Monopoly

More competition Less competition

(less price control) (more price control)
 Characteristics Of Oligopoly
Oligopoly is a market structure in which
1. Natural or legal barriers prevent the entry of new
firms.
Examples of oligopoly industry in Canada:
Airlines, banking, internet service providers.
Barriers to enter: large capital costs, government
regulation.
Natural Barrier To Enter

•Economy of scale can

explain why there is
much more competition
in the restaurant industry
(LRAC1) than in the
airline industry (LRAC2).

•Economies of scale help determine the extent of competition in

an industry

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5
Characteristics Of Oligopoly
2. A small number of firms compete.
–Interdependence: each firm’s profit depends on every
firm’s actions.
–Temptation to Cooperate: firms in oligopoly face the
temptation to form a cartel, to limit output, raise price,
and increase profit. Example: Oil and Petroleum
Exporting Countries
Examples Of Oligopoly Industry
 Games Oligopolists Play
Game theory is a tool for studying strategic
behavior - behavior that takes into account the
expected behavior of others and the mutual
recognition of interdependence.
The four features of a game:
• Rules
• Strategies
• Payoffs
• Outcome
Payoff Matrix
• What is the
best strategies
for Bob and
Art?
Bob’s
view of
the game
Bob’s
view of
the game
Art’s
view of
the game

Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

Art’s
view of
the game
Equilibrium
Dominant Strategy, Equilibrium And Prisoner’s Dilemma
• A dominant strategy: a strategy that is a player’s best
action regardless of the action taken by the other player.
• Nash equilibrium (also known as noncooperative
equilibrium): the outcome when each player chooses the
best strategy, given the action of the other player.
• A situation, in which pursuing dominant strategy results in
noncooperation that leaves both worse off, is called a
prisoner’s dilemma.
 Can Firms Escape the Prisoner’s Dilemma?

•Suppose Domino’s and Pizza Hut are

deciding how to price a pizza: $12 or
$10.
•A clever way to avoid the low-profit
Nash equilibrium is to advertise a price-
match guarantee. Then if either firm
cuts prices, the other has guaranteed to
do so as well.
• Now neither firm will have an
incentive to cut prices.
• Price-match guarantees aren’t as
good for consumers as they appear.

•Changing the payoff matrix in a game with

enforcement mechanism
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16
 Canada’s Not-So Friendly Skies

Why in-country flights in Canada are

significantly more expensive on a
per-kilometer basis than in-country
flights in the United States and to a
larger extent in Europe?

The answer is lack of competition. Foreign carriers are

not allowed to fly between Canadian cities.

© 2015 Pearson Education, Inc.

17
 Canada’s Not-So Friendly Skies

Fewer competitors make it easier to enforce implicit

colluding, having unspoken understandings with one
another not to compete on price.
If one airline cuts prices, the others will retaliate, decreasing
industry profits for all.
Thus, the same route is often identically priced by several
different airlines.

© 2015 Pearson Education, Inc.

18
THE LANDSCAPE OF FIRMS
YOU ARE
Competition HERE
Monopolistic Oligopoly
competition Monopoly

More competition Less competition

(less price control) (more price control)
 What Is Monopolistic Competition?
Monopolistic competition is a market structure in which
▪ many competitors
▪ products similar but not identical: differentiated products
▪ easy entry into and exit from the industry in the long run
Identify monopolistic competitive firms?
Cable television services, wheat, athletic shoes, soft drinks,
hamburger, corn.
Check Your Understanding
You must determine which of two types of market structure
better describes and industry, but you are allowed to ask only
one question about the industry. What question should you
ask to determine if an industry is:
a. Perfectly competitive or monopolistically competitive?
b. A monopoly or monopolistically competitive?
Short-run Profit Maximization
• Same profit maximizing rule as previously used:
1. Produce the Q at which MR = MC.
2. Like monopoly firms, set price according to demand.
Price, cost,
marginal MC
revenue This profit will
attract new ATC
entrants.
Z
P

ATC Profit

This profit cannot

last.
MR D

Q Quantity
Adjustments To Long-Run Equilibrium
• New entrants mean fewer customers for the original
firms: Demand and MR shift left.
Price, cost, • (Economic) profits fall to zero: Firms break even and
marginal new entry stops. MC
revenue

ATC

P
P = ATC
ATC Profit

D
MR
Q Q Quantity
Short-Run Losses And Long-Run Adjustments
• New exits mean more customers for the
remaining firms: Demand and MR shift
right.
Price, cost, MC
marginal
revenue
• (Economic) profits fall to zero: Firms
break even and exits stop. ATC

ATC
Loss
P = ATC

D
MR
Q Q Quantity
The Long-Run Zero-Profit Equilibrium
Price, cost,
marginal
revenue MC

Point of tangency

ATC

Z
PMC = ATCMC

MRMC DMC

QMC Quantity
Comparing Long-Run Equilibrium In PC And MC
• Firms in a monopolistically competitive industry have excess capacity:
produce less than the output at which average total cost is minimized.
• consumers pay higher price but benefit from the extra diversity from
product differentiation.

MC ATC Price, MC ATC

cost,
marginal
Price, cost, revenue
marginal
revenue

PMC= ATCMC

PPC D= MR= PPC

MRMC DMC
QPC Quantity QMC Quantity
Minimum-cost output Minimum-cost output
(a) Long-run (b) Long-run equilibrium in
equilibrium in perfect monopolistic competition
competition
 Measures of Concentration
• The four-firm concentration ratio is the
percentage of the total industry sales accounted
for by the four largest firms in the industry.

• A ratio of less than 60% is an indication of a competitive market.

Measures of Concentration
• Herfindahl-Hirschman Index (HHI), is the square of the
percentage market share of each firm summed over the
largest 50 firms (or summed over all the firms if there are
fewer than 50) in an industry.
• If there are four firms in a market and the market shares of
the firms are 50%, 25%, 15%, and 10%, then HHI =
502+252+152+102
• HHI no greater than 1,800, competitive market.
A Comparison