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7: Imperfect Competition and Strategic Interactions

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    Learning Objectives

    • Markets vary in ways that affect competition and pricing. In some markets, competition is fierce. In others, it is light. Some firms have broad discretion in setting prices, while others face take-it-or-leave-it market prices. Pricing and competition depend on the structural characteristics of the market. Economists classify markets as monopolies, oligopolies, monopolistically competitive, or perfectly competitive depending on the characteristics of selling firms in the market. A brief overview of each market structure is as follows:

      A monopoly is a market with only one seller. The seller (called a monopolist) will often have quite a bit of control over the price that it charges. Earlier in the course, you examined a firm that was a price taker. A monopolist is not a price taker. As the only seller, the monopolist has an incentive to keep its price above its marginal cost. In so doing, it takes surplus from consumers and turns that surplus into profits for itself. Naturally, sellers like to have monopoly power. The problem for the monopolist is to get as much of the consumer surplus as it can. This problem is complicated in that the monopolist faces the market demand curve. Because of the law of demand, the monopolist must lower its price if it wants to sell more, which entails sacrificing its profit margin. On the other hand, if the monopolist attempts to raise price, and thereby increase its profit margin, it sacrifices volume. There is a balancing act here that you have seen before with demand elasticities in Chapter 3. In this chapter, you will see that the demand elasticity facing the monopolist is relevant and can help you solve the monopolist’s problem.

      An oligopoly is a market where there are a few sellers. There must be at least two sellers (a duopoly), and there is no magic number on what constitutes the upper limit of a “few” sellers. Like monopolists, oligopolists do have some discretion in setting their prices. However, the problem is further complicated by the fact that the oligopolist must pay attention to the actions of its competitors. Interactions among competitors are of primary interest in oligopoly models.

      Monopolistic competition refers to situations where there are generally many sellers (again, there is no magic number that divides “few sellers” from “many sellers”). A key feature of monopolistic competition is that products are differentiated in the minds of consumers and/or transactions costs give rise to varied perceptions among consumers as to the advantages or disadvantages of patronizing one firm over another. Because products are differentiated, sellers are not price takers. Like the monopolist, firms in monopolistic competition face a downward sloping demand curve. In fact, you will see that the individual firm’s problem in monopolistic competition has the same set-up as the monopolist’s problem.

      Perfect competition refers to situations where there are many sellers. Products are homogeneous or differ only in ways that readily apparent to all buyers. The actions of any single seller has no effect on the market price. Firms under perfect competition are price takers. The price taking assumption was introduced earlier in Chapter 2. This assumption is the one key feature of perfect competition. While the market demand curve slopes downward, the firm does not face the market demand curve; it only sees the prevailing market price. It can sell all that it wants (or all that it can produce) at the going market price. If the firm attempts to raise its price, there are no buyers. For this reason, it can be said that the firm faces an elasticity of demand that is negative infinity.

      This chapter is about competition and market outcomes under these different market structures. The specific learning objectives for the chapter are as follows:

    • Describe and explain characteristics of different market structures on the selling side of the market.
    • Use the MR = MC profit maximizing condition to find profit maximizing solutions under different market structures.
    • Explain the strategic interactions in duopoly models, distinguish between Cournot and Bertrand models of duopoly, and explain how each is an example of the prisoners’ dilemma
    • Explain the folk theorem and the ability of firms to avoid prisoners’ dilemma outcomes in price competition over time.
    • Understand the economic welfare implications of imperfectly competitive market structures relative to the perfectly competitive benchmark.

    7: Imperfect Competition and Strategic Interactions is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Michael R. Thomsen.

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