1. EC-103
Semester 2
Lectures 6 & 7
Market structure and
Imperfect Competition

2. Most markets fall between the two extremes of
monopoly and perfect competition
• An imperfectly competitive firm
– would like to sell more at the going price
– faces a downward-sloping demand curve
– recognizes its output price depends on the quantity
of goods produced and sold
© The McGraw-Hill Companies, 2002

3. Imperfect competition
• An oligopoly
– an industry with a few producers
– each recognizing that its own price depends both on its
own actions and those of its rivals.
• In an industry with monopolistic competition
– there are many sellers producing products that are close
substitutes for one another
– each firm has only limited ability to influence its output
price.
© The McGraw-Hill Companies, 2002

4. 4
Market structure
Number
of firms
Ability to
affect
price
Entry
barriers
Example
Perfect competition
Imperfect competition:
Monopolistic competition
Oligopoly
Monopoly
Many
Many
Few
One
Nil
Small
Medium
Large
None
None
Some
Huge
Fruit stall
Corner shop
Cars
Post Office
© The McGraw-Hill Companies, 2002

5. Monopolistic competition
• Characteristics:
– many firms
– no barriers to entry
– product differentiation
• so the firm faces a downward-sloping demand curve
– The absence of entry barriers means that profits are
competed away...
© The McGraw-Hill Companies, 2002

6. Monopolistic competition (2)
• Firms end up in TANGENCY
EQUILIBRIUM, making
normal profits
• Firms do not operate at
minimum LAC
• Price exceeds marginal cost
• Unlike perfect competition, the
firm here is eager to sell more
at the going market price.
P1=AC1
£
OutputQ1
D
MR
AC
MC
F
© The McGraw-Hill Companies, 2002

7. Oligopoly
• A market with a few sellers
• The essence of an oligopolistic industry is the
need for each firm to consider how its own
actions affect the decisions of its relatively few
competitors
• Oligopoly may be characterized by collusion
or by non-co-operation

8. Collusion and cartels
• COLLUSION
– an explicit or implicit agreement between
existing firms to avoid or limit competition
with one another
• CARTEL
– is a situation in which formal agreements
between firms are legally permitted
e.g. OPEC

9. Collusion is difficult if:
• There are many firms in the industry
• The product is not standardized
• Demand and cost conditions are changing
rapidly
• There are no barriers to entry
• Firms have surplus capacity

10. The kinked demand curve
Q0
P0
Quantity
£
Consider how a firm may
perceive its demand curve
under oligopoly.
It can observe the current
price and output,
but must try to anticipate
rival reactions to any
price change.

11. Q0
P0
Quantity
£
The kinked demand curve (2)
The firm may expect rivals
to respond if it reduces
its price, as this will be seen
as an aggressive move
… so demand in response
to a price reduction is likely
to be relatively inelastic
The demand curve will
be steep below P0.
D

12. The kinked demand curve (3)
…but for a price increase
rivals are less likely to
react,
so demand may be
relatively elastic
above P0
so the firm perceives
that it faces a kinked
demand curve.D
Q0
P0
Quantity
£

13. The kinked demand curve (4)
Given this perception, the
firm sees that revenue will
fall whether price is increased
or decreased,
so the best strategy is to keep
price at P0.
Price will tend to be stable,
even in the face of an increase
in marginal cost.D
Q0
P0
Quantity
£

14. Game theory: some key terms
• Game
– a situation in which intelligent decisions are
necessarily interdependent
• Strategy
– a game plan describing how the player will act or
move in every conceivable situation
• Dominant strategy
– where a player’s best strategy is independent of
those chosen by others

15. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Game Theory and the
Economics of Cooperation
Game theory is the study of how people
behave in strategic situations.
Strategic decisions are those in which
each person, in deciding what actions to
take, must consider how others might
respond to that action.

16. Game Theory and the Economics
of Cooperation
Because the number of firms in an
oligopolistic market is small, each firm
must act strategically.
Each firm knows that its profit depends not
only on how much it produced but also on
how much the other firms produce.

17. The Prisoners’ Dilemma
The prisoners’ dilemma provides
insight into the difficulty in
maintaining cooperation.
Often people (firms) fail to cooperate
with one another even when cooperation
would make them better off.

18. The Prisoners’ Dilemma
Bonnie’s Decision
Confess Remain Silent
Confess
Remain
Silent
Clyde’s
Decision
Clyde gets
8 years
Bonnie gets
8 years
Bonnie gets
20 years
Bonnie gets
1 year
Bonnie
goes free
Clyde gets
20 years
Clyde gets
1 year
Clyde goes
free

19. The Prisoners’ Dilemma
The dominant strategy is the best
strategy for a player to follow
regardless of the strategies pursued by
other players.

20. The Prisoners’ Dilemma
Cooperation is difficult to
maintain, because cooperation is
not in the best interest of the
individual player.

21. Oligopolies as a
Prisoners’ Dilemma
Iraq’s Decision
High
Production
Low Production
High
Production
Low
Production
Iran’s
Decision
Iran gets
$40 billion
Iraq gets
$40 billion
Iraq gets
$30 billion
Iraq gets
$50 billion
Iraq gets
$60 billion
Iran gets
$30 billion
Iran gets
$50 billion
Iran gets
$60 billion

22. Oligopolies as a
Prisoners’ Dilemma
Self-interest makes it difficult for the
oligopoly to maintain a cooperative
outcome with low production, high prices,
and monopoly profits.

23. Why People Sometimes
Cooperate
Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a
one-time gain.

24. The Prisoners’ Dilemma Game
Consider two firms in a duopoly each with a choice
of producing “high” or “low” output:
Firm B output
High Low
High 1 1 3 0
FirmAoutput
Low 0 3 2 2

25. The Prisoners’ Dilemma
• Each firm has a dominant strategy to
produce high
• so they make 1 unit profit each
• but they would both be better off producing
low
– as long as they can be sure that the other firm
also produces low.
• So collusion can bring mutual benefits
• but there is incentive for each firm to cheat

26. More on collusion
• The probability of cheating may be affected
by agreement or threats
• Pre-commitment
– an arrangement, entered voluntarily, restricting
future options
• Credible threat
– a threat which, after the fact, is optimal to carry
out

27. Strategic entry deterrence
• Some entry barriers are deliberately erected
by incumbent firms:
– threat of predatory pricing
– spare capacity
– advertising and R&D
– product proliferation
• Actions that enforce sunk costs on potential
entrants