Ragan: Economics

Fifteenth Canadian Edition

Chapter 11
Imperfect Competition and
Strategic Behaviour

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Chapter Outline/Learning Objectives
Section Learning Objectives
Blank After studying this chapter, you will be able to
11.1 Imperfect Competition 1. recognize that Canadian industries typically
have either a large number of small firms or a
small number of large firms.
2. explain why imperfectly competitive firms have
differentiated products and often engage in
non-price competition.
11.2 Monopolistic Competition 3. describe the key elements of the theory of
monopolistic competition.
11.3 Oligopoly and Game 4. use game theory to explain the difference
Theory between cooperative and non-cooperative
outcomes among oligopolists.
11.4 Oligopoly in Practice 5. provide examples of the nature of the
competition among oligopolists and the most
common entry barriers.

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 Defining Imperfect Competition
Between the two Extreme (Perfect Competition - Monopoly)

The word imperfect emphasizes that we are not dealing with

perfect competition, in which firms are price takers.

The word competitive emphasizes that we are not dealing

with monopoly.

What are the characteristics that are typical of imperfectly

competitive firms? (see next slides)

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 Characteristics of Imperfectly Competitive Firms?
1. Firms Choose Their Products
• Firms decide the characteristics of the new products to
design and sell.
• Firms sell an array of differentiated products, no two of
which are identical.
• A differentiated product is a group of products similar
enough to be called the same product but dissimilar
enough that all of them do not have to be sold at the same
price.

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2. Firms Choose Their Prices
• Whenever different firms’ products are not identical, each
firm must decide on a price to set.
• Firms that choose their prices are said to be price
setters/price maker.
• A price setter/price makers is a firm that faces a
downward-sloping demand curve for its product. It chooses
which price to set.

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3. Non-Price Competition
Imperfectly competitive firms typically engage in behaviour
that is absent in either monopoly or perfect competition:
• many firms spend large sums of money on advertising
• many firms engage a variety of forms of non-price
competition, such as offering competing standards of
quality and product guarantees
• firms may engage in activities that appear to be designed
to hinder the entry of new firms, which prevents the
erosion of existing profits

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Two in Between Market Structures
We now go into more detail and make a distinction between
industries with:
• a large number of small firms (monopolistic competition)
• a small number of large firms (oligopoly).
The key difference between these two market structures is
the amount of strategic behaviour displayed by firms.

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 11.2 Monopolistic Competition
Monopolistic competition is a market structure of an
industry in which there are:

• Many firms
• Freedom of entry and exit
• Each firm has a differentiated product
• Control over its price
• Demand curve highly elastic / negative slope because
firms produce close substitute

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 Predictions of the Theory (1 of 3)
Profit Maximization for a Firm in Monopolistic Competition in Short Run
In the short run, a monopolistically competitive firm faces a downward
sloping demand curve and maximizes profits by producing the quantity at
which MC = MR.

In the short run it is possible for the firm to make positive profits, break
even, or even to make losses.
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 Predictions of the Theory (2 of 3)
Profit Maximization for a Firm in Monopolistic Competition in Long Run

When firms are making economic profits in the short run, there is an
incentive for new firms to entry the industry.
In the long run, entry of new firms shifts each firm’s demand curve to the
left until profits are eliminated.
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 Predictions of the Theory (2 of 3)
Profit Maximization for a Firm in Monopolistic Competition in long run

In the long run, each firm is producing an output less than that
corresponding to the lowest point on its LRAC curve.
If the firm increases its output, cost per unit decreases but revenue
decreases by more than cost decreases.
So selling more would reduce revenue by more than it reduces cost.
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Predictions of the Theory (3 of 3)
Excess Capacity
When a firm produces an output less than that
corresponding to the lowest point on its LRAC, the firm has
excess capacity.
The excess-capacity theory is the property of long-run
equilibrium in monopolistic competition that firms produce on
the falling portion of their long-run average cost curves.
This results in excess capacity, measured by the gap
between present output and the output that coincides with
minimum average cost.

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11.3 Oligopoly and Game Theory
Oligopoly is an industry that contains two or more firms, at
least one of which produces a significant portion of the
industry’s total output.
Profit Maximization is Complicated
Determining the level of output that maximizes profits is
complicated for an oligopolistic firm because it must consider
its rivals’ likely responses to its actions.
Oligopolists exhibit strategic behaviour—behaviour
designed to take account of the reactions of one’s rivals to
one’s own behaviour.

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 The Basic Dilemma of Oligopoly
Cooperative Strategy / outcome
If firms cooperate to produce among themselves the
monopoly output, they can maximize their joint profits.
If they do this, they reach a cooperative (or collusive)
outcome.
Non-Cooperative Strategy / Outcome
An industry outcome that is reached when firms proceed by
calculating only their own gains without cooperating with
other firms is called a non-cooperative outcome.
Economists use game theory to better understand how
these firms behave.
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Some Simple Game Theory (1 of 4)
Game theory is the theory that studies decision making in
situations in which one player anticipates the reactions of
other players to its own actions.
When game theory is applied to oligopoly:
• the players are firms.
• their game is played in the market.
• their strategies are their price or output decisions.
• the payoffs are their profits.

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Some Simple Game Theory (2 of 4)
1. Consider a two-firm oligopoly called a duopoly, in which
both firms are producing an identical product, and there
is a single market price.
2. The only choice for each firm is how much output to
produce.
3. If the two firms “cooperate” to jointly act as a monopolist,
each firm produces one-half of the monopoly output and
each earns large profits.
4. If the two firms “compete”, they each produce more than
half (say two-thirds) of the monopoly output, and both
firms earn low profits.
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Some Simple Game Theory (3 of 4)
The payoff matrix for this game:
Figure 11-3 The Oligopolist’s Dilemma: To Cooperate or to
Compete?

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Some Simple Game Theory (4 of 4)
A Nash equilibrium is an equilibrium that results when each
player is currently doing the best it can, given the current
behaviour of the other players.
Note that for each firm, the best action is to “compete,” no
matter what the other firm is doing.
So in this game, the Nash equilibrium has both firms
“competing” and producing the higher level of output.

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Figure 11-3 The Oligopolist’s Dilemma: To
Cooperate or To Compete?

But notice that the Nash equilibrium does not maximize joint
profits—this is the classic example of the prisoners’ dilemma!
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 Prisoners’ Dilemma
1. Both plead
innocence:
light sentence
2. Both admit guilty:
medium sentence

3. one who claim

innocent:
severe sentence

4. One admit guilty:

No punishment/free

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Extensions in Game Theory
The simple game described applies to oligopolists producing
identical products.
Game theory can be used in other settings:
• how firms interact when they charge different prices for
their differentiated products.
• how firms interact when the decision is whether to
develop a new product.

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11.4 Oligopoly in Practice
Cooperative Behaviour
When firms agree to cooperate to restrict output and raise
prices, their behaviour is called collusion.
Collusive behavior may occur with or without an explicit
agreement.
Where explicit agreement occurs, there is overt or covert
collusion, depending on whether the agreement is open or
secret.
Where no explicit agreement actually occurs, there is tacit
collusion.

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 The Importance of Entry Barriers
In the absence of natural entry barriers, oligopolistic firms
must create entry barriers if they are to earn profits in the
long run.
1. Brand Proliferation as an Entry Barrier
Think about the many brands of soap, shampoo, breakfast
cereals, or cookies. Each firm in the industry produces
several brands of the differentiated product.
A large number of differentiated products leaves small
market share available to a new firm.

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Brand Proliferation

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2. Advertising as a Barrier to Entry
Where heavy advertising has established strong brand
images for existing products, a new firm may have to spend
heavily on advertising to create its own brand images in
consumers’ minds.
A new entrant with small sales but large required advertising
costs finds itself at a substantial cost disadvantage relative
to its established rivals.

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3. Predatory Pricing as an Entry Barrier
A firm will not enter a market if it expects continued losses
after entry.
Existing firms can create such an expectation by keeping
prices below their own costs until the entrant goes bankrupt.
The existing firm sacrifices profits, but it also discourages
potential future rivals.

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 Activity
The table below is the payoff matrix for a simple two firm game.
Firms A and B are bidding on a government contract, and each
firm's bid is not known by the other firm. & each firm can bid
either $I0000 or $5000. The cost of completing the project for
each firm is $4000. The low-bid firm will win the contract at its
stated price; the high bid firm will get nothing. If the two bids are
equal, the two firms will split the price and costs evenly. The
payoffs for each firm under each situation are shown in the
matrix.

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 Questions
a. ls there a Nash equilibrium in this game?
b. Is there more than one Nash equilibrium? Explain.
c. If the two firms could cooperate, what outcome would you
predict in this game? Explain.

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 Learning Activity 8

Explain with the help of Graph,

how a firm maximize profit under
“Perfect Competition” and
“Monopoly” markets in short Run
and long Run

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